Rothschild v. United States

• Decision Date: 14 February 1969
• Docket Number: No. 130-65.,130-65.
• Citation: 407 F.2d 404
• Parties: Carola W. ROTHSCHILD, Walter N. Rothschild, Jr. and Alan M. Stroock as Executor of the Last Will and Testament of Walter N. Rothschild, and Carola W. Rothschild, Individually, v. The UNITED STATES.
• Court: U.S. Claims Court

407 F.2d 404 (1969)

Carola W. ROTHSCHILD, Walter N. Rothschild, Jr. and Alan M. Stroock as Executor of the Last Will and Testament of Walter N. Rothschild, and Carola W. Rothschild, Individually, v. The UNITED STATES.

No. 130-65.

United States Court of Claims.

February 14, 1969.

Morton L. Deitch, New York City, attorney of record, for plaintiffs; Bernard E. Brandes and Michael M. Umansky, New York City, of counsel.

Joseph Kovner, Washington, D. C., with whom was Asst. Atty. Gen., Mitchell Rogovin, for defendant. Philip R. Miller and Ira M. Langer, Washington, D. C., of counsel.

Before COWEN, Chief Judge, DURFEE, DAVIS, COLLINS, SKELTON, and NICHOLS, Judges.

OPINION

SKELTON, Judge.

This is a suit brought by the executors of the estate of Walter N. Rothschild, deceased, for the recovery of income taxes paid as the result of deficiency assessments involving the years 1955 and 1956, made by the Commissioner of Internal Revenue.^* The dispute arose out of a series of transactions in which the taxpayer, Walter N. Rothschild (now deceased)¹ borrowed funds to make an investment which initially would yield him a loss. However, by deducting the interest paid from ordinary income and paying capital gains tax on the profits of the investment, the taxpayer's investment yielded an after-tax profit.

During the years 1955 and 1956, taxpayer engaged in three separate transactions, borrowing funds (at high rates of interest) to purchase United States Treasury notes, which notes paid interest at rates substantially lower than the interest rates taxpayer agreed to pay on the borrowed funds. In each transaction, the notes purchased had had some interest coupons detached therefrom, thereby making an artificially low purchase price for the taxpayer. Therefore, taxpayer was able to acquire the Treasury notes at less than face value, so that upon their maturity, taxpayer realized a long-term capital gain. Taxpayer reported a long-term capital gain in the amount of $35,184.37 on his 1956 joint income tax return (for the first of the three transactions) and a long-term capital gain in the amount of $52,700 on his 1957 joint income tax return (for the second and third transactions). In connection with these transactions, taxpayer deducted from ordinary income, prepaid interest in the amount of $60,135.42 for the first transaction and in the amount of $93,947.78 for the second and third transactions.

Upon audit of taxpayer's 1955, 1956 and 1957 tax returns, the Commissioner of Internal Revenue disallowed the above interest deductions on the ground that the transactions were entered into solely for the purpose of creating interest deductions for tax purposes, and therefore the deductions were not allowable under section 163(a) of the Internal Revenue Code. The Commissioner of Internal Revenue, therefore, assessed a deficiency against the taxpayer in the amount of $51,531.09 for the year 1955 and in the amount of $58,665.61 for the year 1956.

Taxpayer timely paid the assessment and timely filed claims for refund for the relevant periods. Notices of disallowance of the claims for refund were sent to taxpayer. This suit is timely filed.

The issue is: whether interest paid for borrowed funds to be invested in a transaction which on its face yields no net pre-tax earnings but provides for a built-in economic loss (due to the fact that the interest expense is greater than the maximum possible capital gain) is deductible from ordinary income under section 163(a) of the Internal Revenue Code of 1954.

The facts surrounding the three transactions in which taxpayer participated are fully set out in the findings of fact, infra. All three transactions are substantially identical — they differ only in form, i.e., the banks used, the amounts borrowed and the time of purchase. Therefore, in the interest of simplicity, the facts of the first transaction will be briefly stated as background for this opinion, it being understood that the law is equally applicable to all three transactions.

During the relevant period, taxpayer was a man of substantial means, placing him in the vicinity of the 90 percent tax bracket. Early in 1955, taxpayer was introduced to Lawrence W. Snell, a registered securities dealer in New York City, who operated a brokerage office under the name of Lawrence W. Snell and Company at 60 Wall Street, New York, New York. The purpose of the introduction was for Snell to present taxpayer with a plan which would yield taxpayer a substantial amount of after-tax profit. Although capital gain was the primary concern of the plan presented to the taxpayer, the effectiveness of the plan depended on certain deductions from ordinary income in order to yield an after-tax profit. Snell was aware of this, and the tax consequences were fully discussed with Rothschild. In fact, without the tax deductions, the plan would be unworkable and Snell would not have approached taxpayer with the proposed transaction.

The Transaction

On December 6, 1955, taxpayer purchased from the Snell company for $1,464,815.63, a total of $1,500,000 face value United States 2% Treasury notes, due August 15, 1956. The notes so purchased had the February 15, 1956 and August 15, 1956 interest coupons detached. The Snell company had purchased the notes with the interest coupons attached, through regular channels in the established government bond market. Subsequently, it sold the coupons at a discount (to reflect the interest factor) to a third party. Thereafter, it sold the notes, without the coupons, to the taxpayer for $1,464,815.63.

Snell had previously arranged for the taxpayer to finance the purchase price of the Treasury notes, and in fact, did most of the detail work involved in securing the funds. Snell received a fee from the lender for arranging the loan, which fee constituted his profit on the transaction. Taxpayer signed a full recourse promissory note in the amount of $1,500,000, due August 15, 1956, with interest payable at the rate of 5¾ percent, and gave this note to the Mellon National Bank and Trust Company of Pittsburgh, Pennsylvania (the lending bank). On December 8, 1955, the purchase price of the Treasury notes was remitted to the Snell company and the balance of the $1,500,000 loan ($35,184.37) was remitted to taxpayer.

Snell had the Treasury notes sent directly to the New York correspondent of the lending bank, where they were held as collateral for the promissory note which was executed by the taxpayer. Taxpayer's liability on the promissory note was not limited to the collateral deposited, since the note was a full recourse instrument. Furthermore, the lending bank had the right to call for additional security if it was deemed necessary.

Although the lending bank made no formal investigation into the financial situation of the taxpayer, taxpayer was well known to be a man of substantial means — in fact, during the relevant period, taxpayer's net worth was in excess of five million dollars.

On December 8, 1955, taxpayer prepaid the interest on the note, by transmitting his personal check for $60,135.42 to the lending bank.

At the suggestion of the lending bank, taxpayer directed the bank to redeem the Treasury notes (which were being held as collateral) and apply the proceeds to the satisfaction of his loan. On August 15, 1956, pursuant to taxpayer's request, the lending bank redeemed the notes and applied the proceeds in satisfaction of taxpayer's promissory note.

Section 163(a) of the Internal Revenue Code of 1954 provides that:

§ 163. Interest.

(a) General rule.

There shall be allowed as a deduction all interest paid or accrued within the taxable year on indebtedness.

* * * * * *

(26 U.S.C. § 163, 1964 ed.)

In reviewing previous cases dealing with similar transactions, it is noted that the courts have mentioned at least two general tests to determine the deductibility of interest payments. The varying principles which the courts have enunciated on the subject, have left the area quite unsettled.

One test is commonly called the "business purpose test." According to this, interest is not allowed to be deducted if no economic gain could be realized beyond a tax deduction. Another test, commonly known as the "sham test," is involved in determining whether there is a genuine indebtedness. Here, the courts examine the circumstances surrounding the transaction in order to determine whether the transaction is a sham. If so, then they find that absent any substance to the transaction, there can be no finding of a genuine indebtedness. We will consider the sham cases first.

Historically speaking, these sham test cases grew out of a series of plans devised in the early 1950's by M. Eli Livingstone, a Boston securities broker. By combining section 163(a) with the advantageous tax rate under section 1201 on capital gains, Livingstone was able to offer taxpayers in the high income tax brackets, a substantial tax savings for a relatively small cash expense. These tax savings devices, through judicial interpretation, have become known as "Livingstone transaction." See Goodstein v. Commissioner of Internal Revenue, 267 F.2d 127 (1st Cir. 1959); Lynch v. Commissioner of Internal Revenue, 273 F.2d 867 (2d Cir. 1959).

In the Goodstein case, taxpayer entered into an agreement with Livingstone for the purchase of $10,000,000 of 1 3/8% United States Treasury notes. Purportedly, he gave to Livingstone a $15,000 down payment for the purchase, and Livingstone arranged a loan for the balance of the transaction. Thereupon, Livingstone ordered Guaranty Trust Company of New York (with which he had a security clearance account) to accept delivery of $10,000,000-worth of notes from a bond dealer; Guaranty Trust charged Livingstone's account with the purported purchase price and credited the same amount to the bond dealer. However, within one-half hour of this transaction, Livingstone resold the notes to the dealer, which purported to pay for them with a...