Kahler Corporation v. CIR

Decision Date05 October 1973
Docket NumberNo. 72-1663.,72-1663.
Citation486 F.2d 1
PartiesThe KAHLER CORPORATION, Appellee, v. COMMISSIONER OF INTERNAL REVENUE, Appellant.
CourtU.S. Court of Appeals — Eighth Circuit

Richard W. Perkins, Atty., Tax Div., Dept. of Justice, Washington, D. C., for appellant.

Robert J. Johnson and John W. Windhorst, Jr., Minneapolis, Minn., for appellee.

Before VAN OOSTERHOUT, Senior Circuit Judge, and LAY and ROSS, Circuit Judges.

ROSS, Circuit Judge.

This is an appeal from a decision of the United States Tax Court, 58 T.C. 496, favorable to the taxpayer. The Tax Court rejected the Commissioner's allocation, under 26 U.S.C. § 482, of interest income to a parent corporation as a result of interest free loans made by the parent to its subsidiaries. We reverse with directions to enter judgment in favor of the Commissioner.

The Kahler Corporation (Kahler) has for many years owned and operated a hotel in Rochester, Minnestota. In the early 1960's Kahler established seven wholly owned subsidiaries to operate and manage new hotel or motel properties outside of Rochester. These subsidiary corporations were funded by Kahler. A small portion of the required capital was contributed by Kahler in exchange for all of the stock of the subsidiary. The balance of the required capital was loaned by Kahler on an interest free basis. These advances had no fixed maturity date but were reflected as debts on the books of both the parent and the subsidiaries and were repaid without interest from time to time thereafter.

During the taxable years here involved, 1965 and 1966, four of these subsidiaries were indebted to Kahler in the following amounts:

                          Dec. 31, 1964  Dec. 31, 1965  Dec. 31, 1966
                K.F.M.      $  325,000      $ 315,000     $  293,000
                Mankato        865,000        785,000      1,195,000
                Oak Manor         none        335,000        215,000
                Owatonna       485,000        425,000        385,000
                           ------------    -----------   -----------
                   Total    $1,675,000     $1,860,000     $2,088,000
                

During each of these taxable years, loan repayments were made by the subsidiaries to Kahler although K.F.M and Mankato increased the debt they owed to Kahler. No interest was paid by the subsidiaries on these loans. All of the interest paid by Kahler to banks1 and to Northwestern Mutual Life Insurance Company2 was deducted by Kahler as an ordinary expense of business on its federal income tax return. None of this interest expense was charged by Kahler to its subsidiaries and none of it was claimed by the subsidiaries as deductions on their separate federal income tax returns.3 During oral argument counsel for Kahler conceded that during 1965 and 1966, Kahler owed and paid interest on total indebtedness exceeding the total then owed to Kahler by these four subsidiaries.

Since Kahler's income was substantial, Kahler had a tax benefit from the interest deduction of 48%. If Kahler had charged interest to its subsidiaries, its income would have increased and the tax on the increased income would have been 48%. If the subsidiaries had paid interest to Kahler, they would have been able to deduct it, but much of the benefit of those deductions would have been at the 22% rate. Obviously it was to Kahler's advantage, as sole owner of the subsidiaries, to claim all of the interest deduction and not charge any interest to its subsidiaries.

The Commissioner determined, pursuant to the authority of Section 482 of the 1954 Code (26 U.S.C. § 482),4 and related regulations,5 that interest income, at the rate of 5% per annum, should be allocated to Kahler and assessed a deficiency accordingly.

Correlative adjustments for each of the subsidiaries, increasing their interest expense deductions, were also proposed by the examiner. These allocations and adjustments were proposed upon the Commissioner's determination that such allocation was necessary to clearly reflect the income of both Kahler and its subsidiaries.

The Tax Court upheld the position of Kahler on the ground that the Commissioner failed to show that the interest free advances actually produced income to the subsidiaries and that allocation was improper in the absence of such proof. In so holding, the Tax Court relied upon a line of cases, including Huber Homes, Inc. v. Commissioner, 55 T.C. 598 (1971); PPG Industries, Inc. v. Commissioner, 55 T.C. 928 (1970); Smith-Bridgman & Co. v. Commissioner, 16 T.C. 287 (1951), acq. 1951-1 Cum. Bull. 3; Tennessee-Arkansas Gravel Co. v. Commissioner, 112 F.2d 508 (6th Cir. 1940), which hold that income cannot be created from a transaction where none was actually realized. The Commissioner appealed to this Court citing the recent case of B. Forman Company v. Commissioner, 453 F.2d 1144 (2nd Cir.), cert. denied, 407 U.S. 934, 92 S.Ct. 2458, 32 L.Ed.2d 817, rehearing denied, 409 U.S. 899, 93 S.Ct. 102, 34 L.Ed.2d 158 (1972). We agree with the position taken by the Commissioner and by the Second Circuit in Forman.

In Forman two corporations joined together to form a third corporation with each of the controlling corporations owning 50% of the stock of the new corporation. Each of the controlling corporations made $1,000,000 interest free loans to the newly created corporation. The Second Circuit held that the Commissioner's allocation of 5% interest, as income to the two controlling corporations, was proper under the regulation and that the regulation was consistent with the scope and purpose of Section 482.6

In this case there is no question that the Commissioner's allocation of interest income to Kahler, is consistent with treasury regulation 1.482-2. Therefore, the primary question with which we are presented is whether or not the regulation is unreasonable or clearly inconsistent with the statute. Treasury regulations constitute contemporaneous construction by those charged with administration of these statutes and should not be overruled except for weighty reasons. Commissioner v. South Texas Co., 333 U.S. 496, 68 S.Ct. 695, 92 L.Ed. 831 (1948); B. Forman Company v. Commissioner, supra, 453 F.2d at 1152. We find no such weighty reasons present here.

In determining that the regulation was reasonable and correctly applied to a similar situation, the Second Circuit stated:

"These regulations must prevail, for they are entirely consistent with the scope and purpose of § 482. The instant loans without interest are obviously not at arm\'s length, since no unrelated parties would loan such large sums without interest. The allocation of the interest income to taxpayers was necessary in order to properly reflect their taxable incomes." B. Forman Company v. Commissioner, supra, 453 F.2d at 1156.

The claim that the Commissioner may not create income where none actually existed and thus that the regulations were inapplicable was also analyzed correctly by the Second Circuit in Forman:

"Taxpayers have advanced an argument, supported by case law, that the Commissioner may not create income where none actually existed. In Tennessee-Arkansas Gravel Co. v. Commissioner of Internal Revenue, 112 F.2d 508 (6th Cir. 1940), the court held that the Commissioner could not increase the income of a taxpayer whose property had been used by a related corporation without the payment of rent. The court concluded that, since no rent was called for, none could be created. In Smith-Bridgman & Co. v. Commissioner, 16 T.C. 287 (1951), the Commissioner had added interest to the taxable income of Smith-Bridgman & Co., as allegedly constituting interest which should have been charged by it on noninterest bearing loans to its parent corporation, Continental Department Stores (Continental). Taxpayer did not report as income any interest on these loans. The Tax Court, in overruling the Commissioner, who had allocated interest to Smith-Bridgman, refused to authorize the creation of income where no income was realized. This decision was thought to rest on the fact that the Commissioner had added interest to taxpayer, but had failed to make an adjustment to the income of Continental. However, the rationale of Smith-Bridgeman (sic) was clarified in Huber Homes, Inc. v. Commissioner, 55 T.C. 598 (1971), where it was held that the failure to make the adjustment was only a possible supporting factor, not a controlling factor. Smith was reaffirmed in PPG, Industries, Inc. v.
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