Noteman v. Welch

• Decision Date: 22 December 1939
• Docket Number: No. 3491.,3491.
• Citation: 108 F.2d 206
• Parties: NOTEMAN et al. v. WELCH, Collector.
• Court: U.S. Court of Appeals — First Circuit

108 F.2d 206 (1939)

NOTEMAN et al. v. WELCH, Collector.

No. 3491.

Circuit Court of Appeals, First Circuit.

December 22, 1939.

Richard W. Hale, of Boston, Mass. (Raymond B. Roberts and Hale & Dorr, all of Boston, Mass., on the brief), for appellants.

Robert N. Anderson, Sp. Asst. to the Atty. Gen. (Samuel O. Clark, Jr., Asst. Atty. Gen., and Sewall Key and Arthur A. Armstrong, Sp. Assts. to the Atty. Gen., on the brief), for appellee.

Jackson R. Collins, of New York City, amicus curiae.

Before WILSON and MAGRUDER, Circuit Judges, and PETERS, District Judge.

MAGRUDER, Circuit Judge.

Plaintiffs are trustees of a Massachusetts trust (hereafter referred to as the taxpayer), engaged in the business of making loans under the provisions of the Massachusetts "Small Loans Act."¹ The taxpayer seeks in the present action to recover refunds of corporate surtaxes, additions, and interest collected from it for the taxable year ending September 30, 1935. These sums were assessed by the Commissioner as a result of his determination that the taxpayer fell within the provisions of Section 351 of the Revenue Act of 1934,² which reads, in part, as follows:

"Surtax on personal holding companies

"(a) Imposition of tax. There shall be levied, collected, and paid, for each taxable year, upon the undistributed adjusted net income of every personal holding company a surtax equal to the sum of the following:

"(1) 30 per centum of the amount thereof not in excess of $100,000; plus "(2) 40 per centum of the amount thereof in excess of $100,000.

"(b) Definitions. As used in this title subchapter —

"(1) The term `personal holding company' means any corporation (other than a corporation exempt from taxation under section 101 103, and other than a bank or trust company incorporated under the laws of the United States or of any State or Territory, a substantial part of whose business is the receipt of deposits, and other than a life-insurance company or surety company) if — (A) at least 80 per centum of its gross income for the taxable year is derived from royalties, dividends, interest, annuities, and (except in the case of regular dealers in stock or securities) gains from the sale of stock or securities, and (B) at any time during the last half of the taxable year more than 50 per centum in value of its outstanding stock is owned, directly or indirectly, by or for not more than five individuals."

It was conceded that during the taxable year "more than 50 per centum in value" of the taxpayer's outstanding stock "was owned, directly or indirectly, by or for not more than five individuals". In this appeal from the District Court's decision (26 F. Supp. 437), granting judgment for the Collector, the taxpayer contends that the court should have found, on the evidence, that more than 20 per cent of the taxpayer's gross income, which consisted solely of payments received from borrowers, represented charges for expenses incident to making, servicing and collecting the loans, and that payments by the borrowers attributable to these items are to be differentiated from "interest"; hence that the taxpayer was not a personal holding company within the statutory definition. Further, the taxpayer contends that, even if the Commissioner was right in determining the deficiencies and imposing the surtaxes, the penalties or additions for failure to file returns on Form 1120-H were imposed without authority of law.

Section 351 of the Act of 1934 was aimed at tax avoidance by the scheme of the "incorporated pocketbook", described by a subcommittee of the House Ways and Means Committee as follows: "That is, an individual forms a corporation and exchanges for its stock his personal holdings in stocks, bonds, or other income-producing property. By this means the income from the property pays corporation tax, but no surtax is paid by the individual if the income is not distributed."³ Small loan companies did not present a typical instance of the abuse thus described. Indeed, we cannot find from an examination of the legislative history that either the Congress or its committees considered the possible effect of the pending legislation upon companies engaged in the business of making small loans.

This, of course, does not necessarily mean that such companies are exempt from the tax imposed by Section 351. It not infrequently happens that legislative bodies, with specific instances of abuse in mind, phrase tax legislation in such broad terms as to include persons or groups of persons not specifically contemplated. The alternative is over-particularization, which may lend itself to evasion by clever changes of form or method. In the present instance it was pointed out at the committee hearings that the term "personal holding company" was so broadly defined that legitimate operating companies might be subjected to its provisions.⁴ However, the House was unwilling to make specific exemptions except for banks and insurance companies.⁵ The Senate restricted somewhat the application of these two exemptions, but in response to the urgings of representatives of the real estate business eliminated the word "rents" from the Section.⁶ The committee reports in both the House and the Senate, taking note of the objection that the language of the bill might include some bona fide operating companies which were not formed for any purpose of tax evasion, said that the bill would work no real hardship upon any corporation except one that was being used to reduce the surtaxes of its stockholders, because the corporation "can always escape this tax by distributing to its stockholders at least 90 per cent of its adjusted net income."⁷ Section 351 as finally passed and approved on May 10, 1934, followed the Senate version.

Legislative developments subsequent to 1934 are significant.

During the course of the 1935 hearings on revenue revision before the Senate Finance Committee, Mr. Ellsworth C. Alvord, representing the American Association of Personal Finance Companies (of which the taxpayer is a member), submitted a memorandum⁸ in which it was stated that the gross income of personal finance companies was probably in the nature of "interest", within the meaning of Section 351, and hence that it was desirable that Congress should relieve these companies from the burden imposed by Section 351. Despite this plea, the definition of personal holding company remained unaltered in the Revenue Act of 1935,⁹ nor was any such change made by the 1936 Act. 49 Stat. 1732, § 351. In the Revenue Act of 1937, we find a slight alteration — "personal holding company income" is defined to include "rents, unless constituting 50 per centum or more of the gross income. For the purposes of this subsection the term `rents' means compensation, however designated, for the use of, or right to use, property * * *." 50 Stat. 814, § 353.<sup>10</sup> In H. R. 9682, as introduced into the House March 1, 1938, Section 351 was renumbered Sections 401-406. Section 403(g) amended the definition of "rents" but contained no reference to personal finance companies. However, on March 8, 1938, the following amendment to Section 402(b) was offered and agreed to on the floor of the House<sup>11</sup> without any debate whatsoever: "The term `personal holding company' does not include * * * a licensed personal finance company, under State supervision, at least 80 per centum of the gross income of which is lawful interest received from individuals each of whose indebtedness to such company did not at any time during the taxable year exceed $300 in principal amount, if such interest is not payable in advance or compounded and is computed only on unpaid balances."

The bill was passed in this form by the House. The Senate Committee Report¹² contains no reference to the exception made in favor of personal finance companies. This exception was contained in the Revenue Act of 1938, as finally enacted.¹³

The taxpayer seems to regard the 1938 amendment favoring personal finance companies as being in the nature of a "clarification" designed to prevent the courts from misconstruing Section 351 of the Act of 1934. But the 1938 amendment excepts a personal finance company only if certain specified conditions are met: The company must be licensed; it must be operated under state supervision; at least 80 per cent of its gross income must be "lawful interest"; such "lawful interest" must be received from individuals each of whose indebtedness to the company did not at any time during the taxable year exceed $300 in principal amount; and in addition, such interest must neither be payable in advance nor compounded and must be computed only on unpaid balances. Manifestly, we cannot read into the 1934 act the detailed provisions of the 1938 act with reference to personal finance companies. On the other hand, if the Act of 1934 were construed as not covering any personal finance companies, they would obtain a broader exemption under the earlier act than they now enjoy under the Act of 1938, a conclusion wholly at variance with the legislative history.

In our opinion, therefore, Section 351 of the Act of 1934 cannot be construed to exempt personal finance companies, as such, even though they may be legitimate operating companies, formed for no purpose of tax evasion. Such a company must be held to be covered if at least 80 per centum of its gross income for the taxable year is derived from "interest" and if (as is the case with the taxpayer before us) more than 50 per centum in value of its outstanding stock is owned, directly or indirectly, by or for not more than five individuals.

The gross income of the taxpayer consisted entirely of payments by borrowers. The taxpayer to recover in this suit must establish by a preponderance of evidence that over 20 per cent of such payments was for something other than "interest" within the meaning of Section 351. Reinecke v. Spalding, 280 U.S. 227, 232-233, 50 S.Ct. 96, 74 L.Ed. 385.

"Interest" is not...