United States Fidelity & Guaranty Co. v. Commissioner

UNITED STATES FIDELITY AND GUARANTY COMPANY, PETITIONER, v. COMMISSIONER OF INTERNAL REVENUE, RESPONDENT. United States Fidelity & Guaranty Co. v. Commissioner Docket No. 91398. United States Board of Tax Appeals 40 B.T.A. 1010; 1939 BTA LEXIS 766; December 5, 1939, Promulgated *766 A loan made by the Reconstruction Finance Corporation ostensibly to petitioner's subsidiary, but actually for petitioner's benefit in connection with which petitioner's preferred stock was delivered to the lender, held to justify deduction of payments to the Reconstruction Finance Corporation either as interest paid on petitioner's obligation or as dividends on stock held by an instrumentality of the United States. Revenue Act of 1934, secs. 23(b) and 121. Clarence M. Charest, Esq., and John W. Fisher, Esq., for petitioner. Arthur W. Carnduff, Esq., Ellyne E. Strickland, Esq., and Chester A. Gwinn, Esq., for respondent. OPPER *1010 This proceeding was brought for a redetermination of a deficiency of $19,479.16 in petitioner's income tax liability for the calendar year 1935. The sole issue presented is whether petitioner is entitled to deduct certain payments made to the Reconstruction Finance Corporation during the year in question either as interest paid on a debt under section 23(b) of the Revenue Act of 1934, or as dividends paid to the United States or to any instrumentality thereof under section 121 of the Revenue Act of*767 1934, as added by the Act of August 27, 1935. The facts are presented in a stipulation of the parties and by a record made at the hearing of the case. FINDINGS OF FACT. The stipulated facts are found. In the recital of facts which follows, those facts appearing which are not from the stipulation are our findings of fact otherwise made from the record. Petitioner, a domestic insurance company, was incorporated in 1896 under the laws of the State of Maryland, and since its incorporation has been engaged in the writing of miscellaneous insurance policies and bonds, including all lines of insurance other than fire and life insurance, throughout the United States, Canada, and elsewhere. From the date of its incorporation petitioner constantly expanded its business until the year 1929, when its premium receipts amounted to over $42,000,000, and its total resources at the end of that year amounted to $69,277,792.17. At the end of that year it had over 9,000 agents, a paid-in capital of $10,000,000 and surplus of $16,176,- 835.58, and a surplus as regards policyholders of $26,176,835.58. Beginning in 1930 and continuing during 1931, 1932, and 1933 petitioner's losses under*768 certain lines of insurance, and particularly under *1011 its guaranties of mortgages, became abnormally large, to such an extent as to cause its surplus as regards policyholders to be reduced to $5,278,104.72 and its total resources reduced to $51,287,492.32 at the end of 1933. Petitioner in the course of its business had guaranteed as surety certain mortgages, which were deposited with the trustees to secure the outstanding bonds. Petitioner did not guarantee the collateral trust mortgage bonds sold by the mortgage companies to the public. Its liability as surety was limited to the guarantee of the mortgages and each guarantee ran to a trustee. During 1931 and 1932 petitioner, as surety, was called upon by various trustees to pay and take assignments of many defaulted mortgages. At the peak the total of mortgage guaranties of petitioner was approximately $50,000,000. A plan was submitted to the bondholders under which they had the option to take new bonds in exchange for the old ones, maturing in 20 years, with reduced interest, such bonds to be guaranteed, as to principal and interest, by petitioner, or be paid 30 percent of the face of their bonds in cash and take*769 a 20-year debenture for the remaining 70 percent, such debenture to be guaranteed, as to interest only, by petitioner. The cash required for such a plan was to come from the Reconstruction Finance Corporation (hereinafter referred to as R.F.C.). The mortgage companies for which petitioner had become surety for the payment of the mortgages were merged into one company, the Associated Mortgage Companies, Inc., which was a wholly owned subsidiary of petitioner. This company acquired all of the assets and assumed the liabilities of the mortgage companies which had either become insolvent or were already in receivership. At or about March 1933 petitioner entered into negotiations with the R.F.C. for the purpose of obtaining a loan in excess of $8,000,000, to be made to the above mentioned subsidiary, yet unorganized. By the early part of June 1933 the R.F.C. agreed to the proposed plan and tentatively committed itself to supply the necessary cash. There were many conditions placed on petitioner in connection with the loan, among which was a guarantee by it of the loan and the deposit of substantially all of the bonds before the commitment became effective. The R.F.C. reserved*770 the right to determine later whether it would make the loans to the mortgage companies on the security of the deposited bonds, or whether it would require the actual mortgages, which could be obtained only by the surrender of the bonds to the original trustees. In the meantime petitioner had secured a direct loan on its own behalf from the R.F.C., pledging as security its own stock and bonds. This loan was an ordinary banking transaction that had no relation *1012 to the transaction relating to the mortgage companies. At its peak it amounted to $5,250,00. The plan for refunding the mortgage guaranties provided that it should become effective on or before December 1, 1933, or those who had deposited the bonds would be entitled to have them returned. The R.F.C. would not define what it meant by "substantially all of the bonds." On November 29, 1933, a few days before the plan was to be accepted or rejected, the R.F.C. passed a resolution declaring the plan conditionally effective and extending the time for depositing "substantially all of the collateral trust bonds" until January 31, 1934. Various officials of petitioner were in almost constant contact with the R.F. *771 C., for besides being held in suspense regarding the making of the loan to petitioner's subsidiary, the bondholders were clamoring for their cash and the new instruments due them under the plan. On February 2, 1934, four vice presidents of petitioner, including its actuary, came to Washington at the invitation of the R.F.C. The answer was to be given at that time. The actuary carried with him an official statement of petitioner as of December 31, 1933, in order to show its inherent financial strength. In the conference which followed, Jesse H. Jones, Chairman of the R.F.C., went over the financial statement carefully, and remarked that the item "Bills Payable" in the amount of $4,900,000 did not look well on an insurance company's statement. It was explained that this was the balance of the several loans made to petitioner by the R.F.C. The Chairman wanted to know the amount of preferred stock the company had applied for. He was told that such a thing had never been contemplated and that no such application had been made. Chairman Jones then stated in effect that he thought petitioner should have $4,000,000 additional capital, which the R.F.C. would take; that the R.F.C. attached*772 a good deal of importance to the value of the guarantee of petitioner on the note of the mortgage company; that the R.F.C. was not certain by any means that the mortgages and real estate were adequate security; and that petitioner must endorse the note of the mortgage company. Mr. Jones said he thought petitioner ought to have preferred stock to place it in a strong position to compete with other insurance companies, and that anything that would strengthen it would help R. F. C. Petitioner's officers announced that they had no authority to accept such a proposal. They were advised to withdraw and return with their answer. That same day they returned to announce that they would accept the Chairman's proposition. The decision to accept the proposition of Chairman Jones and issue the preferred stock was reached because the company's officers agreed *1013 with Chairman Jones that it would strengthen the company, and because Chairman Jones was insisting that it be done. The resolution of the R.F.C. dated February 7, 1934, made the issuing of the preferred stock a condition for granting the loan to the Associated Mortgage Companies, Inc. Petitioner proceeded to amend its*773 charter to allow for the issuance of preferred stock. Up to this time there had never been a provision in petitioner's charter for preferred stock. After long negotiation it was decided that petitioner should issue 800,000 shares of preferred stock, with two votes to each share, issued at $1 per share par value and redeemable at $5 per share. The provision for two votes per share was included in order to give the R. F. C. complete voting control of petitioner. The stock certificate also provided that after 299,999 shares of the preferred stock had been retired the remaining shares could be retired only at one and the same time. This was included to insure R. F. C.'s control for the duration of the transaction because the two votes per share on the remaining 500,000 shares gave it the voting control even if the 1,000,000 shares of common stock were voted as a unit. This allowed $3,200,000 of the $4,000,000 to be put in petitioner's surplus account and $800,000 to be added to its capital account. The stock was to pay dividends of 25 cents per share per annum, payable on March 1 and September 1, which was 5 percent yield on $4,000,000. This was the interest rate charged by the*774 R. F. C. at that time. The stock certificate further provided that on dissolution "the holders of the preferred capital stock shall be entitled to receive, out of the assets of the company, for each share of such stock so held by them, the sum of Five Dollars ($5.00) per share, plus an amount equal to all unpaid dividends thereon, whether or not earned or declared, accrued to the date of payment, but shall not be entitled to any other or further payment." The amendment to petitioner's charter pertaining to the issuance of this preferred stock was duly authorized. Some time after February 2, 1934, and about February 17 to February 20, Harold W. Newman, counsel of the R.F.C., asked J. Kemp Bartlett, general counsel of petitioner, to whom had been given the responsibility of carrying through the transaction, if petitioner had a subsidiary. Upon being told that petitioner did have the Del Mar Co., Newman stated that this subsidiary would be used because the R. F. C. preferred to have the note of a borrower. Newman further stated that they wanted a borrower in order to make the proceedings conform with a similar transaction completed by the R.F.C with the Maryland Casualty Co. *775 At no time prior to this conversation between Newman and Bartlett had the Del Mar Co. or any other borrower been mentioned. *1014 In this way the Del Mar Co. (hereinafter for convenience called Del Mar) was brought into the transaction. Del Mar was a wholly owned subsidiary of petitioner and had been organized on November 29, 1920, under the laws of the State of Delaware for the purpose of handling stock in a Canadian insurance company, because a ruling of the insurance commissioner of one of the states had forbidden a domestic insurance company doing business in that state to own stock in a foreign insurance company. There was just enough stock of Del Mar issued to pay for the Canadian company's stock. Up until 1932 Del Mar was not active, had no offices, paid no salaries, and had no expenses except the franchise tax of the State of Delaware. Its officers and directors were officials of petitioner. In 1932, in response to a growing demand by a certain class of purchasers of liability insurance policies to pay the premiums thereon by installments, petitioner had employed a man at a salary of $3,600 per year to build up this installment business. This installment*776 business has been conducted by Del Mar since 1932. It has never been more than a negligible item. The total salaries of Del Mar from 1932 up to the present time have been about $5,000 per annum. It employs three people, two of them being stenographers. Its bank balances even during the years in question seldom amounted to more than a few thousand dollars. In accordance with R.F.C.'s requirements, Del Mar filed a formal application on March 22, 1934, for a loan of $4,000,000 at 5 percent per annum, offering 800,000 shares of petitioner's preferred stock as collateral security. In the working out of the issuance of the preferred stock, both petitioner and Del Mar were required to execute certain documents, which in some cases were parallel sets for each company; those required from the petitioner being far more numerous than those required from Del Mar. These documents placed many limitations upon petitioner not placed on Del Mar, the nominal applicant, such as the limitation that no officer could be paid a compensation of more than $17,500 per annum; that no person could be employed at a compensation in excess of $4,800 per annum unless satisfactory to the R.F.C., and that*777 no dividends could be declared on the petitioner's common stock without the R. F. C.'s consent. A showing had to be made by petitioner that no stockholder owned as much as 10 percent of its capital stock; that no contracts of reinsurance existed which affected the preferred stock. Petitioner had to agree not to put into operation any plan of reorganization and not to retire any of its stocks, notes, bonds, or debentures issued for capital purposes while any of its preferred stock, notes, bonds, or debentures were held by or pledged with the R. F. C. Petitioner also had to agree to bear *1015 all of the expenses of the transaction, including any expenses entailed in its enforcement, and to apply net earnings above the amount necessary to pay the dividends on the preferred stock to no other purpose save the retirement of such stock at the request of the R.F.C. Effective March 31, 1934, and before the final consummation of the transaction, the R. F. C. reduced its interest rate from 5 percent to 4 percent, so that the loan was made to Del Mar at the rate of 4 percent. At first the R.F.C. wanted petitioner to reamend its charter so as to make the dividend of its preferred*778 stock no greater than 4 percent per annum on $4,000,000. Since this was expensive and took time, this problem was solved by having Del Mar and petitioner enter into a supplemental subscription agreement on April 3, 1934, whereby Del Mar agreed that in the event interest due R.F.C. was reduced from 5 percent to 4 percent Del Mar would return to petitioner dividends over and above the interest rate, or would waive dividends over and above interest rate, or would accept from the petitioner, in lieu of the present contemplated cumulative preferred stock, stock exactly the same, except that its dividend rate would conform to the interest rate paybale to the R.F.C. On March 12, 1934, Del Mar entered into an agreement with the R. F. C. whereby it gave up to R. F. C. all voting control of the stock, and agreed to give the R. F. C. all right to exercise any and all rights and powers with respect to the affairs of petitioner as vested in any holder of such stock. It also executed a proxy in favor of R.F.C. as further evidence of R.F.C.'s right to exercise the voting rights of the stock. On April 19, 1934, the transaction was consummated, and the Associated Mortgage Companies, Inc., received*779 from R.F.C. the proposed loan of something over $8,000,000; Del Mar executed and edlivered to R.F.C. its negotiable promissory note for $4,000,000 bearing interest at the rate of 4 percent per annum, payable at the Federal Reserve Bank, Richmond, Virginia, and transferred to the R. F. C. as collateral the certificate of stock for 800,000 shares of the preferred stock of the petitioner made out in the name of the R.F.C. Petitioner received no money for the issuance of the preferred stock but had its notes which were held by the R.F.C. in the then amount of $4,000,000 canceled. During the first year and a half petitioner did not declare any dividend on its preferred stock nor any dividend on its common stock. The interest bills from R. F. C. came to Del Mar and were paid by check by Del Mar after petitioner had placed to the credit of the bank account kept in the name of Del Mar the identical amounts required to pay these bills. Without these deposits Del Mar had no funds with which to meet these payments. At the most it had only *1016 a few thousand dollars in its bank account at any time. The payments of interest amounted to $160,000 per year until a further reduction*780 of its interest rate was made by R.F.C. On the ledger of petitioner these payments were posted on a page entitled "Dividends on Preferred Stock" and after each entry was written "Interest to the R.F.C." for the periods respectively involved. these payments were made on the dates the interest payments were due, i.e., April 19 and October 19 of each year, and not on the dates the dividends were due. Effective November 10, 1935, the interest rate of R.F.C. was again reduced, this time from 4 percent to 3 1/2 percent. In order to take advantage of this reduction petitioner and Del Mar were required by the R.F.C. to enter into an agreement on April 3, 1936, whereby Del Mar again waived all dividends due on petitioner's preferred stock in excess of the amounts required to meet the reduced interest payment to R.F.C. On the same day Del Mar executed an assignment to R.F.C. which recited the agreement with petitioner, and then assigned all dividends accruing on the 800,000 shares of preferred stock to the R.F.C. In September 1936 a dividend was declared on the due date of September 1, in an amount to conform with the interest from April 19, 1936, to that date, instead of the interest-payable*781 date of October 19, 1936. This was the only time the date on which the dividend was declared and paid coincided with the date on which the dividend was payable by the terms of the stock. In its Federal income tax return for 1934 Del Mar deducted $80,219.18 interest paid to R.F.C. on the $4,000,000 loan, and reported a net income of $994.93 and an income tax liability of $136.80, which it paid. It filed an amended return on March 10, 1937, for 1934, reporting among other items income of $80,219.18 as dividends received and $33,333.33 as dividends accrued on the 800,000 shares of petitioner's preferred stock, and reported a net loss. On March 16, 1937, Del Mar filed a claim for refund of the $136.80 tax it had paid for 1934, on the ground that the dividends on domestic corporation stock were not deducted. The claim for refund was allowed but the check in payment has never been cashed and is in the hands of the Board as an exhibit in the case at bar, petitioner having stipulated that it consents to its return to the United States. A similar situation obtains for Del Mar in its 1935 Federal tax. On December 3, 1936, Del Mar paid the R.F.C. the $4,000,000 principal and accrued*782 interest on the note with money furnished it by petitioner. Its note and the certificate of stock were returned, the latter unendorsed. The certificate was canceled. *1017 At its annual meeting of stockholders held January 17, 1938, petitioner's charter was again amended, and petitioner was deprived of the power to issue preferred stock of any kind to anybody. OPINION. OPPER: This proceeding presents the single question of the deductibility of certain payments made in the year 1935 to the Reconstruction Finance Corporation. Briefly stated, the facts giving rise to the controversy are that the petitioner in a prior year and at the request of R.F.C. had paid off a loan owing to the latter from the proceeds of a transaction whereby a note of petitioner's wholly owned subsidiary, the Del Mar Co., and preferred stock of petitioner issued for the purpose, were used to obtain funds from the R.F.C. These funds in turn were repaid to the latter in discharge of the previous obligation. On its face the transaction took the form of an interest-bearing note secured by the preferred stock as collateral. The payments in question were those made to the R.F.C. by Del Mar as "interest", *783 the amounts having been received by the latter from its parent for that purpose but in the form of "dividends" on the preferred stock. Petitioner contends that we may in this situation disregard the corporate existence of Del Mar and treat all of its actions and transactions as though they were in fact those of petitioner. It suggests that this is one of the exceptional cases to which the courts refer when they look through the corporate fiction. The practice, however, of disregarding corporations which the corporate parties themselves have meticulously preserved is one capable of serious abuse. This is particularly true when we are asked to do so for the benefit of the very interests which have themselves chosen to take advantage of the corporate relationship. Cf. . The present circumstances suggest an illustration of the inconsistency which we are asked to approve. Del Mar was organized, according to the testimony, for the purpose of holding stock which, under the law of some jurisdictions, may not be owned by insurance companies. If Del Mar is to be regarded as nonexistent, the very purpose of its formation*784 will be destroyed, because then the ownership of Del Mar will have to be treated as in reality that of its parent, the insurance company. Cf. , reversing . And if that is so, petitioner was in legal contemplation the true owner of the stock in violation of the prohibition of the jurisdictions in question. We are unwilling to accept that formula for dealing with these facts. Nevertheless the transaction which gave rise to the present controversy may profitably be analyzed to determine whether, even if we *1018 accept the separate existence of Del Mar, the terms of the statutes permitting deductions have been rendered inapplicable. 1 As the arrangement was actually carried out only petitioner and R.F.C. were the real participants. Only they obtained any benefit whatever. When the stock was delivered it was issued directly to R.F.C. and in its name. The proceeds were paid to petitioner, which instructed the Federal Reserve Bank of Richmond to apply it on its loan from R.F.C. Upon redemption the stock was received back from the R.F.C. without endorsement, and canceled; and*785 the redemption payment was directed by petitioner's board of directors to be made directly to R.F.C. By the original transaction petitioner accomplished the discharge of its four million dollar liability in exchange for the issuance of a comparable amount of its own preferred stock. R.F.C. obtained every right which could possibly inhere in that stock to the exclusion in every conceivable respect of Del Mar. Even the dividends which were payable by the terms of the issue were relinquished by Del Mar, except to the extent that they had to be transferred through it to discharge the interest obligation to R.F.C. Passing the question of whether under those circumstances Del Mar's note was given for any valid consideration, and assuming that it was intra vires, it seems clear that at most Del Mar's position was that of an accommodation maker. (C.C.A., 4th Cir.). It did not and could not conceivably obtain any benefit from the transaction. It did not receive the funds borrowed nor the stock issued, nor the notes canceled. It was not possible that it ever would receive any benefit. *786 Cf. . If that is so the obligation, whatever it is determined to be, was the equitable liability *1019 of the accommodated party, in this case the petitioner. ; ; (C.C.A., 4th Cir.); certiorari denied, ; see (C.C.A., 4th Cir); ; . The same thing would be true if Del Mar had been an individual, for example, a stockholder, whose name had been signed to an accommodation note because of the lender's insistence. We need not resort to a disregard of Del Mar's corporate existence for that conclusion. *787 If we are correct in this, the payments made to the R.F.C., originating as they all did with the petitioner, and terminating as they all did with R.F.C., were payments on account of petitioner's obligation to the latter. The tax consequence is identical, whether we say that they are payments of dividends on the preferred stock which R.F.C. held, or interest on an obligation which was actually that of the petitioner. That being so, we need not determine which legal phrase more nearly describes them. It is sufficient to hold, as we do, that either as interest paid or as dividends on a domestic insurance company's preferred stock held by an instrumentality of the United States they were deductible under section 23(b) of the Revenue Act of 1934, or section 121 of that Act, as added by the Act of August 27, 1935. 2 Decision will be entered under Rule 50. Footnotes 1. Revenue Act of 1934 - SEC. 23. DEDUCTIONS FROM GROSS INCOME. In computing net income there shall be allowed as deductions: * * * (b) INTEREST. - All interest paid or accrued within the taxable year on indebtedness, except on indebtedness incurred or continued to purchase or carry obligations (other than obligations of the United States issued after September 24, 1917, and originally subscribed for by the taxpayer) the interest upon which is wholly exempt from the taxes inposed by this title. * * * SEC. 121. [Added August 27, 1935] DEDUCTION OF DIVIDENDS PAID ON CERTAIN PREFERRED STOCK OF CERTAIN CORPORATIONS. In computing the net income, for any taxable year beginning after December 31, 1934, of any national banking association, or of any bank or trust company organized under the laws of any State, Territory, possession of the United States, 0r the Canal Zone, or of any other banking corporation engaged in the business of industrial banking and under the supervision of a State banking department or of the Comptroller of the Currency, or of any incorporated domestic insurance company, there shall be allowed as a deduction from gross income, in addition to deductions otherwise provided for in this title, any dividend (not including any distribution in liquidation) paid, within such taxable year, to the United States or to any instrumentality thereof exempt from Federal income taxes, on the preferred stock of the corporation owned by the United States or such instrumentality. ↩ 2. See footnote 1, supra.↩