Stewart v. C.I.R.

• Citation: 714 F.2d 977
• Decision Date: 02 September 1983
• Docket Number: No. 82-7497,82-7497
• Parties: 83-2 USTC P 9573 Spencer D. STEWART, et ux., Petitioners, v. COMMISSIONER OF INTERNAL REVENUE, Respondent.
• Court: United States Courts of Appeals. United States Court of Appeals (9th Circuit)

Page 977

714 F.2d 977

83-2 USTC P 9573

Spencer D. STEWART, et ux., Petitioners, v. COMMISSIONER OF INTERNAL REVENUE, Respondent.

No. 82-7497.

United States Court of Appeals, Ninth Circuit.

Argued and Submitted May 11, 1983.

Decided Sept. 2, 1983.

James Powers, Fennemore, Craig, von Ammon, Udall & Powers, Phoenix, Ariz., for petitioners.

Elaine F. Ferris, Washington, D.C., for respondent.

Review of the United States Tax Court.

Before STEWART ^*, Justice (Retired), DUNIWAY, Senior Circuit Judge, and ALARCON, Circuit Judge.

STEWART, Justice (Retired):

The Commissioner determined that the petitioners, Spencer D. and Mary Jane Stewart (referred to hereinafter as Stewart or the taxpayer ¹), owed federal income taxes in the amounts of $210,751.13 for 1966 and $45,444.21 for 1967. On the taxpayer's petition for review, the Tax Court ² ruled: 1) that interest paid to Stewart by the City of Phoenix, Arizona (the City), pursuant to an agreement under which the City acquired immediate possession of Stewart's water utility for a price to be determined in condemnation proceedings was not exempt from taxation under I.R.C. § 103(a); and 2) that capital gain resulting from the sale of securities contributed by Stewart to a corporation controlled by him should properly be attributed to him. 43 T.C.M. (CCH) 1119 (1982).

I

A

In 1943 or 1944, the taxpayer became the sole owner of the Consolidated Water Company (Consolidated), an unincorporated business which owned and operated utilities that supplied water to households then outside the boundaries of the City of Phoenix. During the 1950's, the City grew rapidly and annexed some of its environs, including parcels in which Consolidated operated the water utility.

Under Arizona law, a city may not build, acquire, or lease a utility plant in an area already served by a public utility until it has purchased the utility for "the fair valuation thereof." Ariz.Rev.Stat.Ann. § 9-515 (1977) ³. This sum may be determined in three ways: by agreement between the city and the utility; by arbitrators agreed upon by both; or by a court in a condemnation proceeding. Ibid.

Prior to 1961, Consolidated sold several water systems to the City, enabling the City's water department to provide service to residents of the newly annexed areas. In early 1962, the City sought to acquire an additional portion of Consolidated's system serving a recently annexed area in northwest Phoenix. The City obtained an appraisal by an engineering firm, which estimated the value of the desired property to be between $2,400,000 and $2,600,000. The City offered to purchase the system at a price consistent with the estimate, but Stewart felt the system was worth over $3,500,000. On July 2, 1962, the City brought an action in the Superior Court of Maricopa County, Arizona, to condemn the property and determine its value. Under the state law in effect at that time, the City could obtain an order granting it immediate possession of the utility only if it deposited with the Superior Court an amount equal to double the probable damages to be sustained by the taxpayer as a result of the condemnation. Ariz.Rev.Stat.Ann. § 12-1116 C (amended 1967). The statute also provided that the parties "may stipulate as to the amount of the deposit, or for a bond in lieu of a deposit." Id. § 12-1116 F.

After the condemnation proceeding was filed, the parties entered into an agreement (the Agreement), which recited that the City desired to obtain immediate possession of the utility and "to secure the waiver of the statutory deposit requirement." The Agreement, which stated that it was not to become effective until approved by the Superior Court, provided that that court would proceed to determine the exact value of the utility in the condemnation action. It stated that in the meantime, the City would obtain immediate possession of the utility, and would pay a total of $2,450,000 for the taxpayer's benefit pending the final decision by the Superior Court. ⁴ The Agreement contained the following provision for the payment of interest on the difference between the amount tendered and the final award:

Any sums which become payable by either party to the other under the terms of the final judgment entered in said condemnation action ... shall bear interest at the statutory rate of six percent per annum from the date City obtains possession of said utility property to the date of payment by the judgment debtor.

The Superior Court entered an order approving the Agreement on July 23, 1962. On September 3, 1964, it entered judgment in favor of the taxpayer for $3,400,000. The Arizona Supreme Court affirmed the Superior Court's judgment in June, 1966. City of Phoenix v. Consolidated Water Co., 101 Ariz. 43, 415 P.2d 866. On October 18, 1966, the City paid the taxpayer an additional $1,180,611.61, of which $239,137.06 was interest required by the Agreement.

The taxpayer did not treat the interest payment as taxable income on his 1966 federal income tax return, taking the position that the payment was interest on a "governmental obligation" and therefore exempt from taxation under I.R.C. § 103(a) ⁵. The Commissioner audited the return and determined that the interest was taxable. The taxpayer challenged this determination in the Tax Court.

Relying on a number of decisions holding that interest on a condemnation award is not excludible under section 103(a), e.g., United States Trust Co. v. Anderson, 65 F.2d 575 (2d Cir.), cert. denied, 290 U.S. 683 54 S.Ct. 120, 78 L.Ed. 589 (1933), the Tax Court concluded that the interest paid by the City pursuant to the Agreement did not fall within the scope of the statutory exemption.

[T]he Agreement was integral to the condemnation proceedings and not a separate arrangement ... and this is determinative of the issue. The provision in the Agreement that provides for interest at the statutory rate of six percent is based on the terms of the final judgment entered in the condemnation action. The Agreement merely provided a means for [Stewart] to obtain funds quickly and for the City to take immediate possession of Consolidated properties without the posting of a bond. To separate the interest obligation from the condemnation award would be to ignore the express language of the Agreement.

43 T.C.M. at 1123 (emphasis in original).

B

During the period in question, I.R.C. § 103(a)(1) excluded from gross income subject to taxation "interest on ... the obligations of a State, ... or any political subdivision of [a State] ...." See n. 5, supra. Similar provisions have been included in the income tax laws since the adoption of the Sixteenth Amendment, when it was widely believed that taxing the recipients of such interest would unconstitutionally burden the ability of state and local governments to borrow funds. ⁶ See United States Trust Co., supra, 65 F.2d at 577; National Life Insurance Co. v. United States, 277 U.S. 508, 521, 48 S.Ct. 591, 593, 72 L.Ed. 968 (1928). Congress' evident purpose in enacting the predecessor of section 103(a) was thus "to safeguard the borrowing power of the states and to prevent taxation which might impair its efficacy ...." United States Trust Co., supra, 65 F.2d at 578.

Where a government's obligation to pay interest arises solely by operation of law, however, taxing the recipient of such interest does not adversely affect the government's ability to borrow money. Recognizing that exemptions from taxation are to be construed narrowly ⁷, federal courts have held that the statutory exemption applies only to interest on obligations incurred by a governmental body pursuant to what is referred to as its "borrowing power." For example, the Court of Appeals for the Third Circuit applied this principle in American Viscose Corp. v. Commissioner, 56 F.2d 1033 (3rd Cir.), cert. denied, 287 U.S. 615, 53 S.Ct. 17, 77 L.Ed. 534 (1932), holding that interest paid by the United States on taxes illegally collected from the taxpayer was not exempt from taxation under § 213(b)(4)(C) of the Revenue Act of 1926, a companion provision to the predecessor of the section at issue here. See Helvering v. Stockholms Enskilda Bank, 293 U.S. 84, 87, 55 S.Ct. 50, 51, 79 L.Ed. 211 (1934) ("The scope of the word 'obligations' [as used in § 213(b)(4)(C) of the Revenue Act of 1926] must be narrowed ..., and not extended to include interest upon indebtedness not incurred under the borrowing power ....")

Consistent with this functional interpretation, other federal courts have long held that the exemption does not extend to interest paid by a state or local government in connection with a condemnation proceeding. Apparently the first decision so holding was in United States Trust Co. v. Anderson, supra, a case in which the Court of Appeals for the Second Circuit concluded that interest paid by the City of New York on a condemnation award was not exempt from taxation. The court, through Judge Augustus Hand, concluded:

An award in condemnation, bearing interest, cannot be regarded as "issued" by a municipality, nor can taxation of the interest received upon such an award in any way affect the borrowing power of the state. There is no bargaining by the municipality in connection with the matter. The owner of the property condemned is obliged to sell it because of the exercise of the right of eminent domain.... It disregards the whole purpose of the exemption to apply it to interest upon obligations of a state which it can compel a citizen to take in exchange for the fair value of his property. The rate of interest is fixed by law, and neither it, nor the amount of the award adjudged as of the time of taking, is a matter over which he has any control.

65 F.2d at 578. Accord Baltimore & Ohio R. Co. v. Commissioner, 78 F.2d 460 (4th Cir.1935). See also Kansas City Southern Railway Co. v. Commissioner, 16 B.T.A. 665 (1929) (holding that interest paid by the United States on compensation awarded to a railroad for...