Campbell v. Carter Foundation Production Company

• Decision Date: 19 September 1963
• Docket Number: No. 18980.,18980.
• Citation: 322 F.2d 827
• Parties: Ellis CAMPBELL, Jr., District Director of Internal Revenue, Appellant, v. CARTER FOUNDATION PRODUCTION COMPANY, Appellee.
• Court: U.S. Court of Appeals — Fifth Circuit

322 F.2d 827 (1963)

Ellis CAMPBELL, Jr., District Director of Internal Revenue, Appellant, v. CARTER FOUNDATION PRODUCTION COMPANY, Appellee.

No. 18980.

United States Court of Appeals Fifth Circuit.

September 19, 1963.

Louis F. Oberdorfer, Asst. Atty. Gen., Lee A. Jackson, Atty., Dept. of Justice, Washington, D. C., Barefoot Sanders, U. S. Atty., W. E. Smith, Asst. U. S. Atty., Dallas, Tex., Michael I. Smith, Atty., Dept. of Justice, Washington, D. C., for appellant.

Harry C. Weeks, Fort Worth, Tex., for appellee.

Before BROWN, WISDOM and BELL, Circuit Judges.

JOHN R. BROWN, Circuit Judge.

In this appeal by the Government from a judgment in favor of the Taxpayer corporation, we are confronted with two questions. The first is whether amounts paid by Taxpayer to its sole stockholder were "interest on indebtedness" entitling Taxpayer to a deduction rather than nondeductible constructive dividends as urged by the Government. The second is whether Taxpayer, as a result of the transfer of assets from the Foundation to its wholly owned Taxpayer operating corporation, gets a stepped-up basis for purposes of depreciation and depletion. As the parties present this, it revolves around the question whether installment notes given by Taxpayer to its sole stockholder in payment for certain assets constituted "stock" or "securities" so as to make the transaction tax-free. The first question we answer favorably to Taxpayer and accordingly affirm that portion of the judgment. As to the second, the Government is correct and we reverse that portion of the judgment.

Foundation¹ (not a party to these proceedings) was a non-profit Texas corporation without capital stock or stockholders, chartered in 1945 for the purpose of supporting religious, charitable and educational undertakings. The status of the Foundation as a tax exempt charitable organization is neither in, nor open to, question here. Foundation received from the late Amon G. Carter and his wife various oil and gas producing properties and other assets, including, in the form in which they then existed, the oil and gas properties involved in this proceeding. With full knowledge that Foundation would operate said oil and gas properties, Foundation was classified as an organization exempt from Federal income tax under § 101(6) of the Internal Revenue Code of 1939 and a Closing Agreement was entered into between Foundation and the then Secretary of Treasury fixing this exempt status.

Until near the end of 1950, Foundation functioned in accordance with its original plan, deriving income from its oil and gas holdings and making therefrom, and from other sources, substantial contributions to educational, religious and charitable organizations, during all of which time the exempt status of Foundation was recognized by the Internal Revenue Service.

Late in 1950, Congress adopted legislation which levied a tax at corporate rates on the "unrelated business taxable income" of organizations such as Foundation.² Organizations such as Foundation were allowed to receive as non-taxable income interest, dividends and royalties as well as certain other types of income. But under the Amendments, a corporation such as this was subjected to a tax upon what may be termed income from ordinary business operations conducted by it. Thus, if Foundation continued to own and operate the various producing properties which it had acquired from its settlor-benefactors, the income from which for the four and one-half years since its organization it had, with the express approval of the Secretary of the Treasury, been permitted to receive without being subjected to corporate tax thereon, it would, after January 1, 1951, be subject to corporate tax upon this income. On the other hand, if its revenues from these properties were limited to interest and royalties, it would not be subject to tax thereon.

It was to meet this situation and to permit Foundation to continue to carry out fully the benevolent program envisaged and intended by its organizers that Taxpayer³ came into being. Taxpayer was chartered under the laws of the State of Texas as an oil producing company on December 26, 1950, with an authorized capital stock of $100,000 fully subscribed and timely paid in cash. From that time and during all of the times involved in this proceeding, all of the outstanding capital stock of Taxpayer was owned by Foundation.

Immediately after its incorporation, Taxpayer purchased from Foundation various oil and gas properties and related depreciable equipment. The total consideration for the purchase of these assets was $2,440,859.10. Of this Taxpayer paid $50,000 in cash and for the balance issued eleven promissory notes in the aggregate amount of $2,390,859.10. The notes were due on or before January 1, 1956. Each note bore interest at the rate of 4% per annum and provided for monthly installments in the amount of $10,000, which payments were to be applied first to interest and then to principal. These notes were secured by vendor's liens. As to the Texas properties transferred, which constituted the major part of the transaction, this meant that Foundation retained a superior title. Foundation also retained overriding royalties on the leases transferred to Taxpayer.

Prior to the time these operating oil and gas interests were transferred to Taxpayer, they were appraised and valued by reputable, competent independent consulting engineers and geologists. Using this report as a basis, the depreciable equipment was assigned a certain portion of the total valuation and Taxpayer treated such assigned portions as its cost of the equipment. In most instances the valuation so assigned to depreciable equipment equaled the total amount of cash and notes given by Taxpayer to Foundation allocated to the particular property. As to two of the leasehold units, the value of the overriding royalty retained by Foundation was deducted. In these two instances no value was assigned on the books of Taxpayer to the oil and gas reserves so acquired. As to the other leasehold units the difference between the total consideration and the amount allocated to equipment was entered on the books of Taxpayer as the cost of depletable reserves.

As found by the Court below, from 1951 to 1955, Taxpayer paid to Foundation $623,351.18 in principal and $431,931.13 as interest.⁴ When the notes matured on January 1, 1956, there was a balance due of $1,767,507.92.⁵

Late in 1955, Taxpayer and Foundation entered into an oral agreement extending the maturity date of the notes for five years. Taxpayer negotiated with a local Bank for a loan to pay off this outstanding indebtedness. However, Taxpayer did not consummate the loan and on October 1, 1956, Foundation cancelled the then unpaid balance due on the notes ($1,475,000) and contributed that amount to Taxpayer as paid-in surplus.

Taxpayer properly filed income and appropriate excess profits tax returns for the calendar years 1951 through 1955 on the cash receipt and disbursement basis of accounting.⁶ In computing its income for these years, Taxpayer deducted from gross income the amounts it had paid to Foundation as interest on the notes. Taxpayer also claimed depletion and depreciation deductions based on the cost it had assigned to the depletable and depreciable property it had bought from Foundation.

The Commissioner asserted deficiencies as to all of the returns. The deductions taken for interest on the notes was disallowed in computing taxable income. The deductions for depreciation claimed by Taxpayer were reduced so as to use as the basis for depreciation the adjusted basis for depreciation which these assets had in the hands of Foundation at the close of the year 1950. As to the properties on which Taxpayer had calculated its allowance for depletion upon its assigned cost, the Commissioner calculated the depletion allowances upon the percentage of income basis.

After payment of the deficiencies, claims for refund and rejection, Taxpayer timely filed this suit for refunds with interest. Trial was had to the Court sitting without a jury and judgment was entered for Taxpayer on both issues for the full amount claimed. It is from this judgment that the Government has appealed.

It was stipulated that the depreciable equipment acquired by Taxpayer from Foundation had the fair market value ascribed to it by Taxpayer, and that, if it was entitled to use its costs for depletion and depreciation purposes, the amounts deducted by it in its tax returns for depletion and depreciation were correctly calculated and deducted.

I.

The Government contends here, as it did below, that Taxpayer was a "thin corporation," and the indebtedness not bona fide so that amounts which it paid to Foundation as interest are to be treated as dividends not deductible by Taxpayer. In this respect the Court below found that "there was in fact here no thin capitalization. At all times Taxpayer had sufficient operating capital to pay for its operations and make the profit that it did make here. At all times, the ratio was on the side of assets of the corporation and not the liabilities * *. Taxpayer is a bona fide corporation, and was at all pertinent times involved in this proceeding. It was the bona fide and actual owner of the properties and actual interests conveyed to it by Foundation * * *." Not only were these findings not clearly erroneous, F.R.Civ.P. 52, but in our opinion it would be difficult to more accurately state the status of Taxpayer in this respect.

The Government contends that the notes were not a bona fide indebtedness because Taxpayer was really under no obligation to pay them off. The Government couples this assertion with the fact that Foundation was the sole stockholder of Taxpayer to support its conclusion that the amounts paid on the notes as interest were dividends in reality. We cannot align ourselves with this theory.

Both the 1939 Code and the 1954 Code provide that there...