325 F.2d 341 (8th Cir. 1963), 17294, Investors Diversified Services, Inc. v. C.I.R.

Docket Nº:17294.
Citation:325 F.2d 341
Case Date:December 13, 1963
Court:United States Courts of Appeals, Court of Appeals for the Eighth Circuit

Page 341

325 F.2d 341 (8th Cir. 1963)




No. 17294.

United States Court of Appeals, Eighth Circuit.

December 13, 1963

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Joseph A. Maun, St. Paul, Minn., and Kenneth M. Anderson, Minneapolis, Minn., made argument for petitioner and were on the brief with counsel, Maun, Hazel, Green, Hayes, Simon & Aretz, St. Paul, Minn., and Cant, Haverstock, Beardsley, Gray & Plant, Minneapolis, Minn.

Harry Marselli, Atty., Tax Division, Dept. of Justice, Washington, D.C., made argument for respondent and Louis F. Oberdorfer, Asst. Atty. Gen., Meyer Rothwacks, Gilbert E. Andrews and Crombie J. D. Garrett, Attys., Tax Division, Dept. of Justice, Washington, D.C., were on the brief.

Before VOGEL, MATTHES and MEHAFFY, Circuit Judges.

MEHAFFY, Circuit Judge.

Investors Diversified Services, Inc. (hereinafter called 'Petitioner') has petitioned us to review a decision of the Tax Court affirming the disallowance of income tax deductions and a claimed refund by the Commissioner of Internal Revenue Service. See 39 T.C. No. 25.

During the years in issue, 1954 and 1955, Petitioner engaged, inter alia, in the sale of loans secured by mortgages to wholly owned subsidiary corporations and non-affiliated purchasers. The gravamen of the petition for review is that as a result of these sales it sustained tax deductible losses within the purview of § 165 of the Internal Revenue Code of 1954


1 and that a portion of the losses attributable to sales to non-affiliates in 1955 was erroneously reported as capital losses when they were actually ordinary losses thereby giving rise to an overpayment of tax and the instant claim for refund.

From its incorporation in 1894 until December 31, 1940, before the enactment of the Investment Company Act of 1940, 15 U.S.C.A. § 80a-1 et seq., Petitioner was in the business of issuing face-amount certificates. These certificates evidenced the obligation of Petitioner to pay the holders thereof designated amounts upon maturity. Petitioner invested the amounts which its certificate holders paid it in real estate mortgages and certain securities.

The National Housing Act was enacted by Congress in 1934, 12 U.S.C.A. §§ 1701-1750. Created thereunder, the Federal National Mortgage Association (hereinafter referred to as 'FNMA') was a government agency formed to purchase insured mortgages from approved mortgagees such as Petitioner. FNMA Provided a secondary market for mortgage loans should the market be such that mortgages could not be sold to conventional sources.

Prior to the enactment of the National Housing Act, Petitioner received an interest rate on its mortgage loans greater than the increment requirement owed the holders of its face-amount certificates. These mortgage loans were of the conventional type (as distinguished from government insured or fully or partially guaranteed by the government) and were usually on an amortized basis for a term of twelve years, eight and two-thirds months, bearing an interest rate of seven per cent. Petitioner's face-amount certificates bore interest rates of from five to six per cent. With the passage of the National Housing Act and the resulting decrease in mortgage loan interest rates, Petitioner became unable to earn sufficient profit to maintain reserves in an amount adequately securing its outstanding face-amount certificates.

The Securities and Exchange Commission (hereinafter referred to as 'SEC') in early 1940 examined Petitioner's assets to determine whether its reserves were sufficient to meet its obligations owed certificate holders. Its reserves were deemed inadequate by some thirty to thirty-three million dollars. Therefore, in compliance with the requirements of the Investment Company Act of 1940, Petitioner discontinued the issuance of face-amount certificates on December 31, 1940.

This prompted Petitioner in that same year to organize Investors Syndicate of America, Inc. (hereinafter referred to as 'ISA'), a wholly owned subsidiary incorporated under the laws of Minnesota and having as its principal place of business Minneapolis. Since 1941 ISA has issued face-amount certificates. Petitioner and ISA are registered investment companies under the provisions of the Investment Company Act of 1940 and classified thereunder as 'affiliated persons' 2 This Act requires that a majority of the board of directors of ISA be persons not affiliated in any way with Petitioner, 15 U.S.C.A. § 80a-10. Although only three of ISA's eight directors were also members of Petitioner's board during the years in issue, from 1940 through 1955 ISA had no personnel of its own and its entire operations were

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conducted by Petitioner. Since 1940 Petitioner was liquidating its own faceamount certificates, acquiring part of its income to pay the increment requirements of these certificates from money loaned on mortgages at interest. To accomplish its mortgage activities, Petitioner established throughout the United States some twenty branch offices which served the functions of both Petitioner and ISA.

Petitioner was not qualified to sell face-amount certificates under the laws of New York State, so prior to 1940 it acquired another wholly owned corporation, Investors Services Title and Guaranty Company (hereinafter referred to as 'IST&G'). IST&G was a corporation qualified to do business in New York where it maintained its offices and had its own separate sales organization.

The Investment Company Act of 1940 prohibited sales of securities between related investment companies which were affiliated as Petitioner and ISA unless exempted by an order of the SEC. On November 13, 1941, the SEC upon application by Petitioner issued an order authorizing sales of mortgages between Petitioner and ISA upon a showing by Petitioner that such sales were in the interest of the public and the investors. 3 The exemption order was periodically renewed remaining on effect throughout the years 1954 and 1955, when the mortgage sales, the subject of this review, occurred. From 1948 through 1955 Petitioner sold substantial quantities of mortgages to ISA as well as some to IST&G under written agreements executed by Petitioner, ISA and IST& G, setting forth as the consideration for such sales basically the terms outlined in SEC's original exemption order, vis-a-vis Petitioner and ISA. Pursuant to these agreements, mortgages in excess of Petitioner's investment needs were sold as rapidly as possible so as to enable it to originate more mortgages.

In 1943 Petitioner decided to increase its profits by engaging in so-called 'participation projects' with affiliated builders of housing projects. Petitioner embarked on such a project but was precluded from pursuing the venture to completion at this time due to sanctions imposed by the SEC for reasons unrelated to the facts culminating in this review. In 1946, these sanctions were removed, whereupon Petitioner reinaugurated the participation projects with affiliated builders. Petitioner financed the acquisition of raw land, the construction of houses and origination of mortgages on the property sold, in exchange for an interest in the profits realized from the development of the subdivision. To acquire a share of such profits, Petitioner either organized a wholly owned subsidiary to be the builder, obtained a 49% Stock interest in a builder, or took a contractual interest in the builder's profits. In addition to an interest in the profits of the builder, Petitioner also derived income from the projects from interest on interim construction loans, fees charged the builder for making construction loans, fees charged the purchaser for making permanent loans, commissions on fire and casualty insurance on the properties, as well as fees for servicing the mortgages sold. Petitioner, being an approved mortgagee, would on occasion when the projects were originated obtain future commitments from FNMA to purchase the mortgage loans.

From the inception of the projects through February, 1954, Petitioner, despite slight fluctuations in the market, received par value or premium price from the sale of these mortgages to its subsidiaries (ISA and IST&G), FNMA under a prior commitment or non-affiliated purchasers.

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During this approximate period, Petitioner's operations produced twenty to twenty-five million dollars in profits over and above other profits and ordinary interest income on mortgage loans and securities held by Petitioner for investment. The slight monthly fluctuations in the mortgage market values apparently did not affect in any substantial way Petitioner's operations or its ability to dispose of its mortgages for par or a premium. However, in the summer or early fall of 1953 the mortgage market took a substantial decline, resulting in mortgage loans selling at below par. Under the National Housing Act, when Petitioner funded a mortgage to the purchaser of a house it was required to pay the full face amount to the mortgagor or borrower regardless of the prevailing mortgage market. The upshot of this disparity was that beginning in the fall of 1953, Petitioner paid par for mortgages which at the time originated had a market value of substantially less than par. Petitioner usually originated its participation project mortgages from six months to two years from the commencement of the project.

When the mortgage market was below par and mortgages were selling at a substantial discount, it was the permissible practice under the Federal Housing regulations for a lender to charge the seller or builder a fee for originating a permanent mortgage to compensate for the mortgage discount. Petitioner did not avail itself of this practice. Instead, When the mortgage...

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