Investors Diversified Services, Inc. v. US, 245-72.

• Decision Date: 19 April 1978
• Docket Number: No. 245-72.,245-72.
• Citation: 575 F.2d 843
• Parties: INVESTORS DIVERSIFIED SERVICES, INC. v. The UNITED STATES.
• Court: U.S. Claims Court

575 F.2d 843

INVESTORS DIVERSIFIED SERVICES, INC. v. The UNITED STATES.

No. 245-72.

United States Court of Claims.

April 19, 1978.

COPYRIGHT MATERIAL OMITTED

David W. Richmond, Washington, D.C., attorney of record, for plaintiff. Barron K. Grier, Robert L. Moore, II, and Miller & Chevalier, Washington, D.C., of counsel.

Kenneth R. Boiarsky, Washington, D.C., with whom was Asst. Atty. Gen. M. Carr Ferguson, Washington, D.C., for defendant. Theodore D. Peyser, Washington, D.C., of counsel.

Before DAVIS, KASHIWA and KUNZIG, Judges.

OPINION

DAVIS, Judge.

For the years 1964 and 1965, plaintiff, Investors Diversified Services (IDS), filed consolidated income tax returns on behalf of an affiliated group of which it was the common parent. One of the members of the group was Investors Syndicate of America, Inc. (ISA), a wholly owned subsidiary of IDS. ISA was a face-amount certificate company registered under the Investment Company Act of 1940, 15 U.S.C. § 80a-28 (1970), and was subject to the banking laws of the state in which it was incorporated, Minnesota. Since its incorporation in 1940, ISA has been a financial institution engaged in the business of issuing, selling, and servicing face-amount certificates, investing in qualified assets, and making payments to certificate holders in accordance with the terms of the certificates.

Those certificates were of two types: installment and single-payment. The vast majority of the face-amount certificates issued by ISA during 1964 and 1965 were of the installment type, under which the holder made periodic payments to ISA over the number of years stated in the certificate (the periods ranged from 6 years to 22 years). Where the holder made payments in accordance with the certificate's terms until the maturity date, ISA agreed to pay the holder, at that time, at least the face amount of the certificate, including an increment over the holder's total payments. The increment was based upon a stated percentage figure (which could not exceed 3 1/2%), compounded annually. ISA also issued some single-payment-type certificates, under which the holder paid ISA a lump sum which was also to mature at a stated date. Upon the maturity of the certificate, ISA agreed to pay the holder the face amount of the certificate, which included a stated increment over the lump-sum amount the holder initially paid to ISA. Here, too, the increment could not exceed 3 1/2% compounded annually. These certificates also provided that the holders could receive additional credits, over and above these stated increments, which could be granted at the option of ISA's Board of Directors, depending upon the investment performance of ISA during a particular year.

ISA could not require a certificate holder to redeem a certificate prior to maturity. That option was vested solely in the holder. Thus, so long as the holder of an installment-type certificate complied with the terms of the certificate, ISA had no right, under the provisions of the certificate, to return his payments or otherwise discharge its obligation to him prior to maturity. Yet the holder had the right to demand at any time payment of the amount credited to his account, and ISA did not have any right to refuse payment on a certificate presented prior to maturity. A holder offering a certificate for redemption prior to maturity got the cash surrender value, as stated on the certificate, plus any applicable additional credits that may have been granted by ISA's Board of Directors. Under the terms of the installment-type certificates having maturity dates of 15 or more years, the "cash surrender value" to the holder was less than the total payments made by the holder until after the end of the eighth certificate year. Nevertheless, at least 50% of the installment-type certificates were surrendered before the end of the eighth year. These purchasers could still have made a profit if sufficient additional credits had been granted by ISA prior to surrender of the certificate.

The certificates were sold by salesmen of the parent IDS in conjunction with the sale of unrelated mutual funds and life insurance. No effort was made by ISA to control the number or type of its certificates sold, and as many certificates were sold as was possible. Investment decisions were also, by contract, handled by IDS.

Under section 28(a) of the Investment Company Act of 1940, 15 U.S.C. § 80a-28(a) (1970), a face-amount certificate company is required to maintain at all times "minimum certificate reserves" on all of its outstanding certificates. The required reserve for each certificate is an amount which, with future payments (if any), when compounded annually at a stated rate of not to exceed 3 ½% will equal the face amount of the certificate at maturity. Sections 28(b) and (c) of the Investment Company Act of 1940 required ISA to deposit and maintain cash or "qualified investments" equal to 100% of this "minimum certificate reserve." "Qualified investments" is defined to mean "investments of a kind which life-insurance companies are permitted to invest in or hold under the provisions of the Code of the District of Columbia * * * and such other investments as the Securities and Exchange Commission shall by rule, regulation, or order authorize as qualified investments." 15 U.S.C. § 80a-28(b) (1970). Generally, qualified investments consist of real estate mortgages, U.S. Government and municipal bonds, and securities of "blue-chip" industrial, finance, public utility, and transportation companies.

In order to maintain the required level of qualified investments, ISA invested its funds in a diversified portfolio. These investment funds came from sales of new certificates, payments received on installment-type certificates previously sold, and from returns on investments previously made — including dividends, interest, repayments of principal and proceeds from the sale of portfolio securities. In 1964 and 1965, approximately two-thirds of the funds available for investment came from ISA's investment portfolio, and about one-third came from sales of new certificates and installment payments on old certificates. As the result of a specific policy and program adopted in 1954, a substantial portion of the company's qualified investments has, since at least 1958, consisted of tax-exempt bonds. In 1964, tax-exempt bonds constituted 29.271% of ISA's qualified investments; in 1965, these bonds formed 28.567% of its total assets. The overwhelming portion of these bonds had maturity dates of 15 or more years, and they were purchased with the intention and practice of holding them until maturity. These tax-exempt bonds, along with others of its securities, were used by ISA (under collateral security agreements) to fulfill the statutory demand that ISA maintain a reserve of qualified assets sufficient to guarantee its face-amount certificate indebtedness.¹

Since IDS filed its consolidated federal income tax returns for 1964 and 1965 on the accrual basis, it deducted as interest expense both the annual increments and additional credits that had been credited on ISA's face amount certificates during those years; this equalled the ratable part of the difference between the amounts which it received from the certificate holder, and the amount which it ultimately would pay to that holder.

Upon auditing IDS's income tax returns for 1964 and 1965, the Internal Revenue Service determined that ISA's interest expenses were partially proscribed by section 265(2) of the Internal Revenue Code. That section provides for the nondeductibility of interest on indebtedness incurred to purchase or carry most obligations on which the interest is exempt from federal income tax.² Since 1964, certain face amount certificate companies, such as ISA, are exempt from this limitation to the extent that the average amount of tax exempts held by the company does not exceed 15 percent of its total assets.

In the statutory notice of deficiency for 1964, the Commissioner determined the total deductible interest and expenses of ISA to be $14,037,083 of which 14.271%,³ or $2,003,232.11, was held to be not deductible under section 265(2). In the 1965 deficiency notice, 13.567%,⁴ or $2,429,334.17, of the $17,906,200.14 of interest and expenses claimed by ISA, was asserted to be non-deductible under section 265(2). As a result of these determinations, the Commissioner assessed a deficiency for 1964 in the amount of $1,036,026.41 and interest thereon in the amount of $411,987.45; the deficiency for 1965 was $1,147,756.77 and interest in the amount of $385,146.64. In due course IDS paid these deficiencies and interest, filed claims for refund, and, having failed to obtain administrative relief, instituted this suit. IDS's claims for refund, however, seek a slightly lower total amount than was assessed by the Commissioner: the 1964 refund claim is only for $1,001,616.06 and $398,303.79 in interest, while the 1965 claim is for $1,166,080.40 plus $385,146.44 in interest.

I

The only issue before us is whether ISA's face-amount certificates represented indebtedness which was incurred or continued to purchase or carry the tax exempt bonds in ISA's investment portfolio, thereby precluding, under section 265(2), see note 2, supra, a portion of the tax deductions for the annual increments and additional credits which ISA credited to the certificates during 1964 and 1965.⁵

In applying this statute a set of general principles is commonly accepted. By direction of Congress, the deduction of interest paid on borrowed money is precluded only if the indebtedness was "incurred or continued to purchase or carry" exempt obligations. No mechanical bar is imposed on the deduction of such interest, for instance by automatic ratable allocation. See Leslie v. Commissioner, 413 F.2d 636, 638 (2d Cir. 1969), cert. denied, 396 U.S. 1007, 90 S.Ct. 564, 24 L.Ed.2d 500 (1970). Accordingly, section 265(2) does not govern unless the...