326 U.S. 521 (1946), 36, 47., John Kelley Co. v. C.I.R.

Docket Nº:Nos. 36, 47.
Citation:326 U.S. 521, 326 U.S. 698, 66 S.Ct. 299, 90 L.Ed. 278
Case Date:January 07, 1946
Court:United States Supreme Court

Page 521

326 U.S. 521 (1946)

326 U.S. 698, 66 S.Ct. 299, 90 L.Ed. 278






Nos. 36, 47.

United States Supreme Court.

Jan. 7, 1946

Argued Oct. 11, 1945.

As Amended Jan. 28, 1946.

Petition by the Commissioner of Internal Revenue against the John Kelley Company for review of a decision of the Tax Court of the United States, 1 T.C. 457, refusing to sustain the assessment of deficiencies in the income and excess profits taxes against John Kelley Company. To review a judgment of the Circuit Court of Appeals, 146 F.2d 466, reversing the decision of the Tax Court, the John Kelley Company brings certiorari.

Petition by Talbot Mills to review a decision of the Tax Court of the United States, 3 T.C. 95, redetermining a deficiency in income and excess profits taxes imposed by the Commissioner of Internal Revenue. To review a judgment of the Circuit Court of Appeals, 146 F.2d 809, affirming the decision of the Tax Court, Talbot Mills brings certiorari.

Decree in Talbot Mills case affirmed and decree in Kelley case reversed.

On Writ of Certiorari to the United States Circuit Court of Appeals for the Seventh Circuit.

On Writ of Certiorari to the United States Circuit Court of Appeals for the First Circuit.

Mr. Justice RUTLEDGE, Mr. Justice BLACK and Mr. Justice BURTON dissenting in part.


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[66 S.Ct. 300] Mr. Frank J. Albus, of Washington, D.C., for petitioner John Kelley co.

Mr. Melville F. Weston, of Boston, Mass., for petitioner Talbot Mills.

Mr. J. Louis Monarch, of Washington, D.C., for respondent.


Mr. Justice REED delivered the opinion of the Court.

These writs of certiorari were granted to examine the deductibility as interest of certain payments which the

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taxpayer corporations made to holders of their corporate obligations. Although the obligations of the two taxpayers had only one striking difference, the noncumulative in one and the cumulative quality in the other of the payments reserved under the characterization of interest, the Tax Court (formerly the Board of Tax Appeals, 56 Stat. 957, 26 U.S.C.A.Int.Rev.Code, s 1100; only its present name will be used herein) held that the payments under the former, the Kelley Company case, were interest and under the Talbot Mills were dividends. The Circuit Court of Appeals reversed the Tax Court in the Kelley case and another circuit affirmed the Talbot Mills decision. 1 On account of the diversity of approach in the Tax Court and the reviewing courts, we granted certiorari.

[66 S.Ct. 301] In the Kelley case, a corporation, all of whose common and preferred stock was owned directly or as trustee by members of a family group, was reorganized by authorizing the issue of $250,000 income debenture bearer bonds, issued under a trust indenture, calling for 8% interest, non-cumulative. They were offered only to shareholders of the taxpayer but were assignable. The debentures were payable in twenty years, December 31, 1956, with payment of general interest conditioned upon the sufficiency of the net income to meet the obligation. The debenture holders had priority of payment over stockholders but were subordinated to all other creditors. The debentures were redeemable at the taxpayer's option and carried the usual acceleration provisions for specific defaults. The debenture holders had no right to participate in management. Other changes not material here were made in the corporate structure. Debentures were issued to the amount of $150,000 face value. The greater part, $114,648, was issued in exchange for the original preferred, with six per

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cent cumulative guaranteed dividends, at its retirement price and the balance sold to stockholders at par, which was eventually paid with sums obtained by the purchasers from common stock dividends. Common stock was owned in the same proportions by the same stockholders before and after the reorganization.

In the Talbot Mills case the taxpayer was a corporation which, prior to its recapitalization, had a capital stock of five thousand shares of the par value of $100 or $500,000. All of the stock with the exception of some qualifying shares was held by members, through blood or marriage, of the Talbot family. In an effort to adjust the capital structure to the advantage of the taxpayer, the company was recapitalized just prior to the beginning of the fiscal year in question, by each stockholder surrendering four-fifths of his stock and taking in lieu thereof registered notes in aggregate face value equal to the aggregate par value of the stock retired. This amounted to an issue of $400,000 in notes to the then stockholders. These notes were dated October 2, 1939, and were payable to a specific payee or his assignees on December 1, 1964. They bore annual interest at a rate not to exceed 10% nor less than 2%, subject to a computation that took into consideration the net earnings of the corporation for the fiscal year ended last previous to the annual interest paying date. There was, therefore, a minimum amount of 2% and a maximum of 10% due annually and between these limits the interest payable varied in accordance with company earnings. The notes were transferable only by the owner's endorsement and the notation of the transfer by the company. The interest was cumulative and payment might be deferred until the note's maturity when 'necessary by reason of the condition of the corporation.' Dividends could not be paid until all then due interest on the notes was satisfied. The notes limited the corporation's right to mortgage its real assets. The notes could be subordinated

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by action of the Board of Directors to any obligation maturing not later than the maturity of the notes. For the fiscal year in question the maximum payment of 10% was made on the notes.

The payments in question on corporate obligations were for the years in the Kelley case, 1937, 1938 and 1939; in the Talbot Mills case for the year 1940. Both corporations deducted the payments as interest from their reports of gross income under statutory sections and regulations set out in the footnote. 2 The applicable statutes [66 S.Ct. 302] and regulations were identical for all periods. The Commissioner asserted deficiencies because the payments were considered dividends and not interest.

There is not present in either situation the wholly useless temporary compliance with statutory literalness which this Court condemned as futile, as a matter of law, in Gregory v. Helvering, 293 U.S. 465, 55 S.Ct. 266, 79 L.Ed. 596, 97 A.L.R. 1355. The demonstrated

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possibility of sales by the holders of the obligations to persons other than stockholders alone proves the differentiation. As material amounts of capital were invested in sock, we need not consider the effect of extreme situations such as nominal stock investments and an obviously excessive debt structure.

From the foregoing statements of facts, if appears that the characteristics of all the obligations in question and the surrounding circumstances were of such a nature that it is reasonably possible for determiners to reach the conclusion that the secured annual payments were interest to creditors in one case and dividends to stockholders in the other case. In the Kelley case there were sales of the debentures as well as exchanges of preferred stock for debentures, a promise to pay a certain annual amount, if earned, a priority for the debentures over common stock, the debentures were assignable without regard to any transfer of stock, and a definite maturity date in the reasonable future. These indicia of indebtedness support the Tax Court conclusion that the annual payments were interest on indebtedness. On the other hand, in the Talbot Mills case, the Tax Court found the factors there present of fluctuating annual payments with a two per cent minimum, the limitation of the issue of notes to stockholders in exchange only for stock, to be characteristics which distinguish the Talbot Mills notes from the Kelley Compoany debentures. Upon an appraisal of all the facts, the Tax Court reached the conclusion that the annual payments by Talbot Mills were in reality dividends and not interest.

We think these conclusions should be accepted by the Circuit Courts of Appeals and by ourselves. Judicial review of Tax Court decisions depends upon the Internal Revenue Code, Section 1141(c) Powers (1), 26 U.S.C.A.Int.Rev.Code s 1141(c)(1). It reads:

'To affirm, modify, or reverse. Upon...

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