Dillon, Read & Co., Inc. v. U.S.

• Decision Date: 16 May 1989
• Docket Number: No. 89-1001,89-1001
• Citation: 875 F.2d 293
• Parties: -1325, 89-1 USTC P 9327 DILLON, READ & CO., INC., Dillon, Read & Co., Dillon, Read Overseas Corp., Dillon, Read Real Estate Inc. and Nassau Associates, Inc., Plaintiffs-Appellants, v. The UNITED STATES, Defendant-Appellee.
• Court: U.S. Court of Appeals — Federal Circuit

Page 293

875 F.2d 293

63 A.F.T.R.2d 89-1325, 89-1 USTC P 9327

DILLON, READ & CO., INC., Dillon, Read & Co., Dillon, Read Overseas Corp., Dillon, Read Real Estate Inc. and Nassau Associates, Inc., Plaintiffs-Appellants, v. The UNITED STATES, Defendant-Appellee.

No. 89-1001.

United States Court of Appeals Federal Circuit.

May 16, 1989.

John V. Thornton, Whitman & Ransom, New York City, for plaintiffs-appellants. George J. Noumair and Michael T. Kiesel, Whitman & Ransom, of New York City, were on the brief, for plaintiffs-appellants.

Calvin C. Curtis, Dept. of Justice, Washington, D.C., for defendant-appellee. With him on the brief were James I. K. Knapp, Acting Asst. Atty. Gen., Gary R. Allen and Richard Farber. William S. Rose, Jr., Dept. of Justice, Washington, D.C., of counsel.

Before MARKEY, Chief Judge, NICHOLS, Senior Circuit Judge, and NEWMAN, Circuit Judge.

NICHOLS, Senior Circuit Judge.

Dillon, Read & Co. Inc. (Dillon, Read) and Affiliates appeal from the judgment of the United States Claims Court, Dillon, Read & Co. Inc. v. United States, 15 Cl.Ct. 246 (1988), granting the United States' motion for summary judgment. We vacate and remand.

I. Background

This is one more of the now lengthy series of tax cases in the lower federal courts dealing with a belief on the part of the Internal Revenue Service (IRS) that the taxpayer has claimed an interest deduction for cost it has incurred in carrying tax-exempt securities. The taxpayer, Dillon, Read, ¹ is an investment banking firm which acts as a broker and dealer in stocks and securities. Dillon, Read makes a profit, in part, by buying securities and selling them to customers.

In the course of its business, Dillon, Read incurs various expenses, such as salaries, rent, and the purchase of securities, among other things. Dillon, Read borrows funds when its expenses exceed internally available funds. It owns tax exempts, as stock in trade, just as it owns securities whose fruits are taxable.

When faced with the decision of whether to borrow funds, Dillon, Read does not base its decision on the availability of capital which it could raise through the sale of the securities it holds in inventory to persons other than customers. So, likewise, the decision of whether to increase the inventory of securities is not based on the availability of funds. Thus, the decision to purchase securities and the decision to borrow funds are segregated functions.

Once the decision to purchase securities is made, internal funds are used if available and borrowed funds are used if needed. The borrowed funds are usually collateralized by the securities (taxable and tax-exempt) which Dillon, Read holds for ultimate sale to its customers. Because the borrowed funds are commingled with Dillon, Read's other funds, it is not possible to attribute the proceeds of any one loan to a specific purpose; likewise, it is not possible to tie any one security which collateralizes a loan to a specific purpose. Thus, the decision of which securities to use as collateral is wholly removed from the need for which the loan was incurred, a need which cannot be specified other than to say it was for the general business purposes of Dillon, Read. Disregarding, as we must, a belated attempt by Dillon, Read to supplement the record, we see nothing in it to support any inference that collateralizing any security removes it from availability as stock in trade, and we disregard, too, a belated attempt by the government to show the contrary.

Section 265 of the Internal Revenue Code ² (I.R.C. or Code) provides in pertinent part:

No deduction shall be allowed for--

(2) Interest

Interest on indebtedness incurred or continued to purchase or carry obligations the interest on which is wholly exempt from the taxes imposed by this subtitle * * *.

This statute was construed in the celebrated case of Wisconsin Cheeseman, Inc. v. United States, 388 F.2d 420 (7th Cir.1968), celebrated at least to tax aficionados. The Cheeseman case involved a taxpayer, Cheeseman, who was in the business of packaging fancy cheeses for sale as Christmas gifts. After the cash-rich months of its seasonal business, Cheeseman purchased tax-exempt municipal bonds. During the cash-poor months, Cheeseman used the municipal bonds as collateral for short-term bank loans, the proceeds of which were used to meet the business' needs for working capital. The Cheeseman court decided that the underlying reason for the short-term loans was to carry tax-exempt obligations, and therefore section 265(a)(2) disallowed a deduction for the interest expenses incurred for the short-term loans.

The case of Leslie v. Commissioner, 413 F.2d 636 (2d Cir.1969), involved the investment banking firm of Bache & Co., (Bache) a firm in the same line of business as Dillon, Read. Bache borrowed money in much the same fashion as does Dillon, Read. That is, the decision to borrow funds was not made on the basis of the availability of securities held in inventory, and borrowed funds were commingled with other funds. Thus, borrowed funds could not be traced to a specific purpose.

Approximately one percent of the securities held by Bache were tax-exempt securities, although none of the tax-exempt securities were used as collateral for loans. Bache was unable to trace its interest expenses to specific activities or purchases, and it simply deducted all of its interest expenses. The Leslie court held that I.R.C. Sec. 265(a)(2) disallows a deduction for that portion of interest expenses equivalent to the portion of Bache's total assets made up of tax-exempt securities. Thus, if one percent of Bache's total assets were tax-exempt securities, Bache could not deduct one percent of its interest expenses.

We have considered rather numerous decisions by our predecessor the old Court of Claims dealing with section 265(a)(2), Investors Diversified Services, Inc. v. United States, 575 F.2d 843, 216 Ct.Cl. 192 (1978); Phipps v. United States, 515 F.2d 1099, 206 Ct.Cl. 583 (1975); Phipps v. United States, 414 F.2d 1366, 188 Ct.Cl. 531 (1969); Illinois Terminal R.R. v. United States, 375 F.2d 1016, 179 Ct.Cl. 674 (1967), and by this court, E.F. Hutton Group, Inc. v. United States, 811 F.2d 581 (Fed.Cir.1987) and Barenholtz v. United States, 784 F.2d 375 (Fed.Cir.1986).

We have applied the Leslie formula in E.F. Hutton, supra. Dillon, Read followed the approach of the Leslie case and did not deduct that portion of its total interest expenses equivalent to the percentage of its total assets which are tax-exempt obligations. The IRS audited Dillon, Read's returns for 1974-1977 and determined that the interest deductions taken in those years were overstated. According to the IRS, the interest expense for loans collateralized with tax-exempt securities should be disallowed under the Cheeseman holding; the remaining interest expenses should be allocated according to the Leslie holding. The total disallowance is the Cheeseman disallowance plus the amount disallowed per the Leslie allocation.

Dillon, Read paid the deficiencies assessed by the IRS and filed suit in the Claims Court to recover the taxes paid. On motion for summary judgment, Dillon, Read sought a determination it terms "the Cheeseman corollary." The Cheeseman corollary proposes that if interest on loans collateralized with tax-exempt obligations is conclusively nondeductible, then interest on loans which are collateralized with taxable obligations is conclusively deductible. Under this theory, the total disallowance would be the Cheeseman disallowance unaugmented by the Leslie allocation. The Claims Court denied the motion, Dillon, Read & Co. Inc. v. United States, 11 Cl.Ct. 529 (1987), explaining that the proceeds of loans collateralized with taxable securities can be used to purchase tax-exempt obligations, a prohibited purpose under section 265(a)(2). For this reason, interest expenses for loans collateralized with taxable securities are not conclusively deductible.

On cross-motions for summary judgment, Dillon, Read reverted to the approach initially followed on its tax returns whereby the Leslie allocation is applied to total interest expenses (the pure Leslie approach), and the IRS pursued its combined Leslie/Cheeseman approach. The Claims Court granted the government's motion for summary judgment. On appeal, Dillon, Read presses the pure Leslie approach, and as a secondary alternative, it presses the Cheeseman corollary.

II. Issues

(A) Whether interest expenses for loan proceeds not traceable to the purchase or carrying of tax-exempt obligations should be conclusively deductible or nondeductible according to the loans' collateralization.

(B) Whether interest expenses for loan proceeds not traceable to the purchase or carrying of tax-exempt obligations should be allocated proportionally among all the uses of the taxpayer without regard to the loans' collateralization.

The judgment appealed from was rendered on cross-motions for summary judgment. The parties have stipulated to the material facts; therefore we review the judgment solely for its correctness as a matter of law. Kircher v. United States, 872 F.2d 1014, 1018 (Fed.Cir.1989).

III. Discussion

As a preliminary matter, we note that neither party argued at trial or on appeal that jurisdiction is barred by the variance doctrine, an issue raised sua sponte by the Claims Court, i.e., Dillon, Read did not consistently maintain throughout the history of this case that the Leslie formula governed. Rather, at one time it urged its "Cheeseman corollary." We see no error in the Claims Court's treatment of this issue and need not add to that court's discussion of it. Dillon, Read, 15 Cl.Ct. at 250.

A. The Cheeseman Corollary

We are in agreement with the Claims Court that collateralization of loans in part with taxable obligations is not conclusive evidence that the taxpayer lacked a prohibited purpose. As the Claims Court explained, collateralization with...