Staked Plains Trust v. Commissioner of Internal Rev.

• Decision Date: 28 June 1944
• Docket Number: No. 10980.,10980.
• Parties: STAKED PLAINS TRUST, Limited, v. COMMISSIONER OF INTERNAL REVENUE.
• Court: U.S. Court of Appeals — Fifth Circuit

143 F.2d 421 (1944)

STAKED PLAINS TRUST, Limited, v. COMMISSIONER OF INTERNAL REVENUE.

No. 10980.

Circuit Court of Appeals, Fifth Circuit.

June 28, 1944.

J. P. Jackson, of Dallas, Tex., for petitioner.

Joseph S. Platt, Sewall Key, Helen R. Carloss, and Newton K. Fox, Sp. Assts. to the Atty. Gen., Samuel O. Clark, Jr., Asst. Atty. Gen., and J. P. Wenchel, Chief Counsel, Bureau of Internal Revenue, and Charles E. Lowery, Sp. Atty., Bureau of Internal Revenue, both of Washington, D. C., for respondent.

Before SIBLEY, HUTCHESON, and LEE, Circuit Judges.

LEE, Circuit Judge.

In its income tax return for 1937 petitioner deducted the sum of $29,750 as interest accrued on indebtedness under Section 23(b) of the Revenue Act of 1936, 26 U.S.C.A. Int.Rev.Code, § 23(b). The Commissioner disallowed the deduction on the ground that the sum did not represent interest due on an indebtedness. The Tax Court sustained the Commissioner and the taxpayer brought the case here for review.

The taxpayer, a trust taxable as a corporation, was formed in 1914 to take over and develop or sell in subdivisions a tract of 60,000 acres of land in Texas acquired in 1912 by Texas Prairie Lands, Ltd., a Canadian corporation. In 1912 the corporation issued bonds in the sum of $2,433,333.33, which were secured by a mortgage on the land. In 1914 it issued Prior Lien Notes in the sum of $500,000, which also were secured by a mortgage on the land to which the bondholders' mortgage was subordinated, and the noteholders also became owners of Profit Sharing Certificates. The entire beneficial interest in the trust assets, represented by 35,000 shares, was issued to the corporation and by it deposited as additional security for payment of the bonds. The trustees were empowered to borrow money, to issue additional beneficial interest shares containing preferential provisions, to manage the project free of interference, and to declare distributions.

In 1916 the enterprise needed additional liquid resources. After borrowing $100,000 in September, a second trust called Prairie Lands Trust, Ltd., was formed December 1, 1916. To this trust, in consideration of the assumption by it of certain obligations of the taxpayer, including the $100,000 debt, the taxpayer conveyed certain contracts of purchase and vendor's lien notes, together with physical equipment and its accounts receivable, and the shareholders of the new trust were guaranteed a return of $375,000 plus interest at six percent. The new trust secured funds with which to perform its obligations from the proceeds of subscriptions for its beneficial interest, represented by 4,250 equal shares, to which the bondholders' security was subordinated.

In December, 1919, pursuant to a plan and agreement to reorganize the entire enterprise, the new trust retransferred to the taxpayer all its assets then remaining, whereupon the bonds and notes of the original corporation and the beneficial interest shares of the new trust were cancelled and retired. The taxpayer exchanged "Liquidation Certificates (Class A)" for the Prior Lien Notes and Profit Sharing Certificates, and "Liquidation Rights Certificates (Class B)" for the trust shares. The Class A Certificates were in an aggregate principal sum of $570,000, and entitled the owners thereof to the payment in full of a specified principal sum with interest before any payment should be made upon the Class B Certificates. The Class B Certificates provided that each registered holder thereof was entitled to liquidation rights of the Staked Plains Trust, Limited, "redeemable by payments to be made out of the funds of the said trust from time to time when and as authorized by the Trustees" for the total sum of $160 plus interest at 7% per annum from January 1, 1920, for each right; that no payments should be made until all Class A Certificates had been paid; and that no payments in liquidation should be made upon the shares of the trust until all the liquidation rights had been redeemed in full.

The property was operated under the reorganization plan continuously after 1919. As of December 31, 1937, the entire principal of the Class A Certificates had been paid, and the interest had been reduced to $202,422.58. No payment of any kind had then been made to holders of Class B Certificates. It was with respect to the Class B Certificates that the taxpayer accrued interest in the sum of $29,750 in its tax return for 1937. The legality of the deduction depends upon whether the Class B Certificates were an indebtedness of the taxpayer within the purview of Section 23(b), supra.

The applicable portion of this statute provides that in computing net income there shall be allowed as a deduction all interest paid or accrued within the taxable year on indebtedness.¹ The judicial decisions have uniformly construed this statute to authorize deductions of interest paid or accrued where the strict legal relationship of debtor and creditor existed between the taxpayer and the payee of the interest, and have with equal uniformity determined that the deduction does not apply where the payee participates by virtue of his ownership of a proprietary interest in the assets of the taxpayer.² In the latter instance the payment is not of interest to a creditor, but a distribution of dividends to a shareholder.³ Whether the holders of the Class B Certificates were creditors of the...