Philadelphia Nat. Bank v. U.S.

• Decision Date: 11 December 1981
• Docket Number: No. 81-1331,81-1331
• Citation: 666 F.2d 834
• Parties: 81-2 USTC P 9821, 2 Ed. Law Rep. 32 PHILADELPHIA NATIONAL BANK and Philadelphia National Corporation, Appellees, v. UNITED STATES of America, Appellant.
• Court: U.S. Court of Appeals — Third Circuit

Page 834

666 F.2d 834

81-2 USTC P 9821, 2 Ed. Law Rep. 32

PHILADELPHIA NATIONAL BANK and Philadelphia National Corporation, Appellees, v. UNITED STATES of America, Appellant.

No. 81-1331.

United States Court of Appeals Third Circuit.

Argued Oct. 14, 1981.

Decided Dec. 11, 1981.

John F. Murray, Acting Asst. Atty. Gen., Michael L. Paup, Gary R. Allen, David I. Pincus (argued), Tax Division Dept. of Justice, Washington, D. C., for appellant; Peter F. Vaira, Jr., U. S. Atty., Philadelphia, Pa., of counsel.

Robert R. Batt, Richard Z. Freemann, Jr. (argued), Bonnie S. Brier, Thomas B. Roberts, Philadelphia, Pa., for appellees; Ballard, Spahr, Andrews & Ingersoll, Philadelphia, Pa., of counsel.

Before HUNTER, ROSENN and WEIS, Circuit Judges.

OPINION OF THE COURT

WEIS, Circuit Judge.

Interest on money borrowed by political subdivisions is exempt from federal income tax. In this case, the district court concluded that Temple University, a state-related school in Pennsylvania, had sufficient governmental functions and powers to qualify as a political subdivision. Our review of the record, however, persuades us that although the university has close ties with and is dependent upon the state, a delegation of essential governmental power did not take place. Accordingly, we reverse a judgment in favor of the plaintiff bank which had received interest from Temple.

Philadelphia National Bank sued the United States for a refund of taxes paid on interest received from loans to Temple University, contending that under § 103(a)(1) of the Internal Revenue Code, 26 U.S.C. § 103(a)(1) (1976), the university was a "political subdivision." After a bench trial, the district court entered judgment in favor of the bank in the amount of $474,402.

The facts in the case are largely undisputed. Temple University, a private non-profit corporation in Philadelphia, was founded in 1888 as an educational institution. Under the direction of its Board of Trustees, the school expanded its activities over the years to become a major metropolitan university, but growing financial difficulties required it to consider a change in its structure. Temple's fiscal need coincided with the Commonwealth's desire to meet its constitutional obligation to provide public education by extending opportunities for university training. Recognizing that a formal relationship with the state would be mutually beneficial, the school agreed to reorganization in 1965 pursuant to the Temple University-Commonwealth Act. 24 Pa.Con.Stat.Ann. § 2510-1 et seq. (The Commonwealth Act).

One of the major reasons for the legislation was the state's desire to reduce tuition rates by providing financial assistance through annual appropriations. In addition, by statutorily "incorporating" the university into its educational system, the state avoided the much greater cost of establishing and constructing a new public university. Report of Higher Education Committee, House of Representatives, Commonwealth of Pennsylvania, 1965-66 at 39-40.

The stated purpose of the Act is "to extend Commonwealth opportunities for higher education by establishing Temple University as an instrumentality of the Commonwealth to serve as a State-related institution in the Commonwealth system of higher education." Id. at § 2510-2. The institution was renamed "Temple University-Of The Commonwealth System of Higher Education" to reflect its new status. Id. at § 2510-3. This section provides that, as renamed, Temple "shall continue as a corporation for the same purposes as, and with all rights and privileges heretofore granted to, Temple University, unless hereinafter modified or changed."

As a consequence of the legislation, Temple reconstituted its Board of Trustees to consist of 36 regular members and three ex-officio members, the Governor of Pennsylvania, the Secretary of Education, and the Mayor of Philadelphia. Id. at § 2510-4(a). Twelve of the 36 members are designated as Commonwealth Trustees and are appointed by the Governor, President pro tempore of the Pennsylvania Senate, and Speaker of the Pennsylvania House of Representatives. Id. at § 2510-4(b).

The state imposes some controls on the university. For example, it is subject to audit of expenditures by the State Auditor General. Moreover, the President of the school must make an annual report to the legislature.

The General Assembly is empowered to set tuition schedules whenever it makes adequate appropriations to the university, but otherwise the management and control of the instructional, administrative, and financial affairs of the university are entrusted to the Board of Trustees.

Temple receives capital improvement benefits comparable to those given land grant colleges and state colleges. For example, the Commonwealth, by agreement with Temple, may "acquire lands, erect and equip buildings, and provide facilities for the use of the university." Id. at § 2510-7.

Although it is precluded from pledging the credit of the Commonwealth, "the board of trustees may provide for the issuance of bonds in the name of the university for any proper purpose in the same manner as heretofore." Id. at § 2510-9(a). Such obligations, and the income therefrom, are not taxable by the Commonwealth. Id. at § 2510-9(c).

After the legislation was enacted, the state's annual appropriation to Temple rose from $20,106,998 in 1966 to $44,568,000 in 1971-72. These amounts represented 50.6% to 62.7% of the unrestricted revenue of the school. During the same period, the General State Authority of Pennsylvania built nine structures for Temple. Land for five of these was acquired in part by condemnation, and in four instances the Authority received the land by conveyance from the university. By 1971, the General State Authority owned 40% of Temple's physical plant. The State does not charge Temple for the use of these facilities nor is there a lease with the school. Property acquired by Temple before 1966 remains in the university's name.

Because the annual Commonwealth appropriations were either inadequate or delayed during the years 1967 through 1971 Temple had to borrow extensively from the plaintiff bank. The proceeds were used to pay operating expenses and to redeem debenture bonds. The interest rate on each loan was set at the regular commercial rate, and was not discounted because of an expected interest exemption from federal income taxes.

After considering the relationship between Temple and the State created by the legislation, the district court concluded that Temple is "a political subdivision in a modern form" and that, as an instrumentality of the state, the university borrows " 'on behalf of' the Commonwealth of Pennsylvania." The court commented that Temple "exercises (even if it might not be said to 'possess') every significant sovereign power necessary to effectuate (Pennsylvania's policies for higher education.)" This is so, according to the district court, because Temple has a campus police force and charges tuition for performing a recognized public service, akin to tolls on state-owned turnpikes. In addition, Temple is a beneficiary of eminent domain through its requests to the General State Authority to condemn certain property. ¹

On appeal, the United States argues that Temple is a private, non-profit corporation, governed by a privately controlled Board of Trustees, and has not been delegated sovereign power. The bank contends that Temple is an instrumentality of the state, carries on a public function, possesses police power, and enjoys benefits from the state eminent domain and taxation powers. In addition, the bank asserts that the university issues obligations "on behalf of" the state.

The bank can obtain a § 103 exemption if Temple is deemed to be a political subdivision or if Temple issued the obligations "on behalf of" the state. We will discuss these possibilities separately.

The starting point must be the statute itself. In pertinent part it reads:

"(a). Gross income does not include interest on-(1) the obligations of a State ... or any political subdivision of any of the foregoing ...."

26 U.S.C. § 103(a)(1).

The statute is explained somewhat by a longstanding Treasury Regulation which defines political subdivisions as "any division of any State or local governmental unit which is a municipal corporation or which has been delegated the right to exercise part of the sovereign power of the unit." 29 C.F.R. § 1.103-1(b).

There is surprisingly little decisional law on what constitutes a political subdivision within the meaning of § 103. The Supreme Court has never addressed the issue, and the leading-and almost only-cases on point were decided by the Court of Appeals for the Second Circuit. Commissioner of Internal Revenue v. Shamberg's Estate, 144 F.2d 998 (2d Cir. 1944), cert. denied, 323 U.S. 792, 65 S.Ct. 433, 89 L.Ed. 631 (1945), and Commissioner of Internal Revenue v. White's Estate, 144 F.2d 1019 (2d Cir. 1944), cert. denied, 323 U.S. 792, 65 S.Ct. 433, 89 L.Ed. 632 (1945).

In Shamberg, the court held that interest paid on bonds issued by the Port of New York Authority was exempt from federal income tax. The Authority, a body politic and corporate, had been created by a compact between New Jersey and New York and was governed by a Board of Commissioners, whose members were appointed by the two states.

The Authority was formed to construct and operate toll bridges and tunnels in the New York area, was granted the power of eminent domain and was immunized from suit. It had a police force whose members were designated by statutes of both states as regular police and peace officers. The Authority also had the power to make and enforce regulations governing the operation and maintenance of bridges and tunnels within its control. 144 F.2d at 1002-03.

The court of appeals held that the Authority's activities were "exercised for a public purpose by an agency set up by the states and given many public powers,...