
    382 F. 2d 298
    CUYUNA REALTY COMPANY v. THE UNITED STATES
    [No. 326-63.
    Decided July 20, 1967]
    
      
      Quinn O'Connell for plaintiff; Robert T. Malloy, attorney of record. Gerald J. O'Rourke, Jr., and Weaver, Glassie <fb Molloy, of counsel.
    
      Joseph Kovner, with whom was Assistant Attorney General Mitchell Rogovim,, for defendant. Philip R. Müler and Richard J. Boyle, of counsel.
    Before CoweN, Chief Judge, Laeamoee, Duefee, Davis, ColliNs, SeeltoN, and Nichols, Judges.
    
   Laeamoee, Judge,

delivered the opinion of the court:

This is but another version of .the debt-versus-equity controversy arising so frequently in the tax field. The facte are simple; they involve the deductibility of accrued and unpaid interest on demand notes given to a parent corporation by its wholly-owned and always-insolvent subsidiary.

In 1912 Cuyuna was organized under Minnesota laws as a subsidiary of Northwestern Improvement Company (NWI) which paid $10,000 par value for all of Cuyuna’s authorized and issued capital stock. NWI organized Cuyuna and two other subsidiaries at about the same time to transfer to them all land in Minnesota owned by it in excess of 5,000 acres, in order to comply with a Minnesota statute which then restricted corporate ownership of land to that quantity, with irrelevant exceptions.

Because the new subsidiaries were without funds, NWI agreed to accept their demand promissory notes for the properties transferred, and to accept similar notes for future advances to be made by NWI for their expenses and additional property acquisitions. In November 1912 Cuyuna purchased certain mining leases (optioned by NWI) from the Hill Company for $207,437.50, paying $47,437.50 in cash and giving back $160,000 in promissory notes for the' balance. NWI advanced Cuyuna $37,437.50 for the downpayment (added to the $10,000 paid for capital stock this furnished the down-payment) , and before the end of the year purchased $156,000 of the plaintiff’s notes from Hill Company. Cuyuna redeemed the remaining $4,000 note to Hill Company in 1916. In February 1913 Cuyuna issued its demand note for $772,-294.25 to NWI as payment for the transfer of certain properties and leases. In August 1913 Cuyuna issued NWI its further demand note dated July 1,1913, for $133,751.28 covering advances by NWI (including interest) for the year ending June 30, 1913. In August 1914 Cuyuna issued another demand note to NWI dated July 1, 1914, for $363,060.14 covering the latter’s advances (including interest) for the year ended June 30, 1914, plus interest on Cuyuna’s other notes held by NWI. By then Cuyuna’s notes issued to or held by NWI totaled $1,462,543.17.

Cuyuna accrued interest on its hooks, covering its notes with NWI, but never paid any. By October 31, 1956, the unpaid interest accruals totaled $3,648,819.58. On November 20, 1956, NWI gratuitously canceled, forgave and discharged the interest accruals by corporate resolution, giving as reason the fact that Cuyuna had at all times since its organization been “hopelessly insolvent”, and “there is no possibility that it will ever be able to pay any part of said accrued interest”. When Cuyuna was recapitalized on December 21, 1956, the notes to NWI were canceled on its own books. The stipulated facts are not informative as to Cuyuna’s business over the relevant period of its existence, so it cannot be determined whether it was ever intended to be or had the prospects of being a viable enterprise. Its perennial insolvency would seem to negate the idea.

In its Federal income taxes for 1952-1956 Cuyuna claimed deductions for interest accrued on its notes held by NWI, which interest NWI had not accrued as income in its returns. Cuyuna’s returns for the years 1952-1956 reported other income and expense in the net amount of $27,598.98, as opposed to $428,414.45 interest accruals on the notes held by NWI, for a net loss of $400,815.47.

On its returns for the years 1957-1960 Cuyuna claimed net operating loss deductions for the carryover of the losses claimed for the years 1952-1956. "Upon audit the Commissioner of Internal Revenue disallowed the loss carryovers and assessed resulting deficiencies on the ground that the deductions of interest accruals on which they were based were improper. On April 8,1963, Cuyuna paid the deficiencies of $132,534.04, pins interest thereon of $27,802.35. On August 8, 1963, a timely claim for refund was filed and rejected November 14, 1963. This suit followed immediately.

The sole issue is whether the interest accruals by plaintiff arose from valid items of indebtedness between plaintiff and its parent, entitling plaintiff to deductions for Federal income tax purposes. Section 163 of the Internal Revenue Code of 1954 (26 U.S.C. § 163), and section 23 of the 1939 Code, allowed as deductions from gross income in computing net income “all interest paid or accrued within the taxable year on indebtedness”. To satisfy tire Code provision there must be (1) a debt and (2) interest thereon (3) accrued within the taxable year. It is conceded that interest on the notes in question was accrued annually. That leaves for determination the sole question whether the notes were a debt, as the plaintiff contends, or a capital investment, as the defendant insists. Which it was involves consideration of various factors, no one of which is controlling.

Treasury Regulation 1.166-1 (c) provides as follows:

* * * A bona fide debt is a debt which arises from a debtor-creditor relationship based upon a valid and enforceable obligation to pay a fixed or determinable sum of money. * * *

Mertens says:

The important underlying principle is that no valid debt exists unless there is an u/nconditional obligation of another to pay the taxpayer. It is the sine qua non of the existence of the debt and accordingly of the right to deduct worthless debts. * * * To constitute a valid debt, there must not only be a legal obligation to repay, but the money must have been advanced with reasonable belief at the time that it would be repaid. 5 Mertens, Law of Federal Income Taxation, § 30.03, 1963 rev. [Emphasis in original.]

Claim to a debt relationship in a parent-subsidiary transaction merits particular scrutiny because the control element suggests the opportunity to contrive a fictional debt, an opportunity less present in an arms-length transaction between strangers. This is not to preclude the possibility that a parent-subsidiary transaction may constitute a bona fide indebtedness; it is merely a warning to be wary. The term indebtedness must be strictly construed. Interest deductions cannot be claimed if there is no indebtedness. It is the taxpayer’s burden to establish the indebtedness. The distinction between indebtedness and risk capital is that a loan is made upon the reasonable assumption that it will be repaid no matter whether the business venture is successful or not, while capital is put to the risk of the business.

It is likely that the advances by NWT to Cuyuna in exchange for the latter’s notes were intended to create a debtor-creditor relationship at the times they were made in 1912-1914. They were not made to avoid taxes. All but $363,050.14 of the notes totaling $1,462,543.17 were issued prior to the Revenue Act of 1913, 38 Stat. 173. None of the notes would have given plaintiff a tax benefit for the interest accruals at the time the notes were issued, for the Revenue Act of 1909 (36 Stat. 113) and the Revenue Act of 1913, supra, permitted deductions of interest actually paid on debts, rather than interest accruals. We are not informed why NWT preferred to advance funds and transfer properties to Cuyuna in exchange for unsecured demand notes, rather than to subscribe to increases in Cuyuna’s capital stock sufficient to produce equivalent funds. Presumably how they wished to accomplish this was their business. It is clear that the motive for the creation of subsidiaries was to circumvent legally the Minnesota statute restricting land holdings by corporations.

In most of the cases in this area, the inquiry has been whether “at the time of the issuance of the instrument * * * [the parties intended] to create a real debtor-creditor relationship.” Jack Daniel Distillery v. United States, ante at 308, 326, 379 F. 2d 569, 580 (1967), and cases cited therein. Understandably, plaintiff urges us to make the same inquiry here. That inquiry is not the ultimate test, however. The real issue in all these cases is whether there is “indebtedness” on which interest has “accrued within the taxable year,” and although this issue can perhaps usually be resolved by examining the initial intention of the parties, that cannot always be the case. The income tax law looks to events in each tax year, Burnet v. Sanford & Brooks Co., 282 U.S. 359 (1931), so in applying section 163, it is proper for courts to inquire for each tax year whether there is indebtedness. A rule that the original intention of the parties should control the character of an instrument for all time would be completely inconsistent with the purpose of the statute. Interest, like an ordinary business expense, is allowed as a deduction from income because it is a cost of producing income. It ceases to be a real cost, if with the passage of time it becomes apparent that the parties have no intention of continuing the debtor-creditor relationship.

The cases which hold that interest continues to accrue even if the debtor has no intention or expectation of ever paying it are not to the contrary. E.g., Fahs v. Martin, 224 F. 2d 387 (5th Cir. 1955); Zimmerman Steel Co. v. Comm'r, 130 F. 2d 1011 (8th Cir. 1942). They involve situations in which a valid debtor-creditor relationship continues right into and through bankruptcy proceedings. We are concerned with the situation in which the continuance of the relationship is in question. Surely a parent’s advance to a subsidiary may start out as bona fide indebtedness, and may continue as such into insolvency, but the character of indebtedness may vanish when the parent and the subsidiary cease acting like debtors and creditors; perhaps that point is passed when the parent, unlike the reasonable creditor, fails to force the subsidiary into bankruptcy.

In the present case, we can assume Cuyuna intended at the outset to meet the notes and interest due NWI, and NWI expected that Cuyuna’s operations would be sufficiently profitable to do this. However, we may infer from the resolution of the NWI directors in 1956 stating “Cuyuna Realty Company has operated at a deficit since its organization and, is hopelessly insolvent * * that it was clear in 1956, and undoubtedly long before then, that there was no debtor-creditor relationship. There can be no doubt that NWI would not have permitted an unrelated debtor to fall so far behind in its payments. The 1956 resolution was not the result of a sudden realization that there was no longer a reasonable expectation of profitable operations. This becomes particularly apparent if we look back to 1952, the first tax year here involved, and view the situation at that time in the light of the indicia that have been developed by the cases. We note that the only hallmark of indebtedness was the form of the transactions, while there were many indicia of contributions to capital: e.g., (1) complete identity of interest between Cuyuna and NWI; Affiliated Research, Inc. v. United States, supra; (2) advances were not repayable upon any fixed maturity date with the exception of the notes to Hill Company assumed by NWI and never paid; John Wanamaker Philadelphia v. Comm'r, 139 F. 2d 644, 647(3d Cir. 1943); (3) grossly inadequate ratio of debt to equity; Affiliated Research, supra; (4) advances were proportionate to NWI’s 100 percent stock ownership; Ibid.; (5) no attempt was made by NWI to enforce payment of the obligations; Wood Preserving Corp. v. United States, 347 F. 2d 117, 119 (4th Cir. 1965); O. H. Kruse Grain & Milling v. Comm'r, 279 F. 2d 123, 125 (9th Cir. 1960); (6) no outside lender woidd have made or continued true loans upon the same conditions; Jack Daniel Distillery v. United States, supra; American Processing and Sales Co. v. United States, 178 Ct. Cl. 353, 371 F. 2d 842 (1967); Affiliated Research; Wood Preserving Corp.; Kruse Grain & Milling, supra.; (7) most of the advances were used to acquire capital assets; Wood Preserving Corp., supra; and (8) Cuyuna had no funds and its income was never sufficient to make any payments on the advances.

In an effort to avoid the application of the above-cited cases and their numerous brethren, plaintiff will now concede that the $772,294.25 demand note which was issued in February 1913 to NWI as payment for the transfer of certain properties and leases was a contribution to capital. This, of course, materially changes the debt-equity ratio and transforms an otherwise “thin incorporation” into something of apparent substance. Plaintiff’s eleventh hour attempt cannot succeed here, however, because there is no proof that the contribution of the land to the equity capital of the corporation would have provided a sufficient earnings base to carry the outstanding indebtedness. There is nothing inconsistent with this and our conclusion that plaintiff has proved a business purpose and absence of tax motivation in casting the 1912-1914 transactions in the form of debt. We are simply saying that for plaintiff to recast successfully the earlier transactions into a form that will preserve the interest deduction, it must prove that the new form shows a true debtor-creditor relationship with respect to the tax years before us. It is this burden that plaintiff has not met.

In conclusion, we hold that plaintiff had no indebtedness on which interest accrued in the tax years 1952-1956. Judgment is entered for defendant, and plaintiff’s petition is dismissed.

BINDINGS OK FACT

The court, having considered the evidence, the report of Trial Commissioner C. Murray Bernhardt, and the briefs and argument of counsel, makes findings of fact as follows:

1. Cuyuna Realty Company (hereinafter referred to either as “taxpayer” or “Cuyuna”) was organized and incorporated in November 1912 under the laws of the State of Minnesota. Northwestern Improvement Company (hereinafter referred to as “NWI”), a domestic corporation, and parent of taxpayer, subscribed and paid for all of plaintiff’s authorized and outstanding capital stock, having a par value of $10,000 at the time of taxpayer’s organization, and owned all of such stock during all times material herein.

2. On September 28, 1912, NWI was given an option to acquire an ore mining lease held by the C. M. Hill Lumber Company (hereinafter referred to as “the Hill Company”) covering certain properties located in Crow Wing County, Minnesota. On November 27, 1912, taxpayer exercised the option and acquired the leases from the Hill Company, in return for, $200,000, plus $7,437.50 accrued royalities due. In order to exercise the option, taxpayer had to borrow $37,437.50 from NWI. Thereafter, in payment for the leases taxpayer transferred $47,437.50 to the Hill Company, and, in addition, issued 16 promissory notes, as follows:

No. Vue Vate Amount
1 November 27, 1913 $16, 000
2 16, 000
3 4,000
4 4, 000
5 November 27, 1914 16, 000
6 16, 000
7 4, 000
8 4, 000
9 November 27, 1915 16, 000
10 16, 000
11 4, 000
12 4, 000
13 November 27, 1916 16, 000
14 16, 000
15 4, 000
16 4, 000
Total 160, 000

Taxpayer’s cash account was closed following these transactions. All of the notes bore interest at the rate of 5 percent per annum. Before the end of 1912 NWI acquired the first 15 of such notes, in the face amount of $156,000, from the Hill Company and held them at all times material thereafter. The remaining $4,000 note (No. 16) was redeemed by taxpayer in 1916.

3. Prior to 1911 the State of Minnesota had enacted a Statute prohibiting corporations from holding more than 5,000 acres of land, with exceptions not material here. NWI held title (fee and leasehold) to more than 60,000 acres of land in Minnesota. In order to comply with the Minnesota statute, a plan was devised to transfer title to some of that land to three newly organized subsidiary corporations, including Cuyuna. The plan provided that NWI would convey the excess lands to the new subsidiary corporations for a consideration equal to the amounts directly invested by NWI in those lands, plus certain other expenditures prorated among the lands transferred. In addition, the plan provided as follows:

The consideration for the property transferred will be paid by the new companies giving the Improvement Company demand notes bearing interest at 6%. As the new companies have no funds at present to meet further expenditures for royalties, taxes, expenses or new property acquired, the Improvement Company will from time to time advance such additional money as is needed.
It will be observed that the financial adjustment is as of date June 30, 1912; at the end of each fiscal year a further adjustment will be made by charging to the new companies all expenditures made during the year on their account, plus interest, and notes will be made by the three companies to cover.

4. On February 19, 1913, NWI transferred certain properties to Cuyuna in exchange for taxpayer’s demand note of that date for $772,294.25, and bearing interest at the rate of 6 percent.

5. On August 15, 1913, taxpayer’s board of directors authorized the issuance of a demand note, to be dated as of July 1, 1913, for $133,751.28 covering advances from NWT of $129,958.57 during the 12-month period ended June 30, 1913, and interest thereon, from the date of receipt of the advances to June 30, 1913, of $3,792.71. Taxpayer’s books reflect recordation of this note.

6. On August 18, 1914, taxpayer’s board of directors authorized the issuance of a promissory note, to be dated as of July 1, 1914, for $363,060.14, to cover advances of $240,-276.36 from NWT during the period ended June 30, 1914, interest to June 30,1914, on those advances in the amount of $6,077.68, plus interest in the amount of $116,706.10 on taxpayer’s notes which were previously acquired by NWI. Taxpayer’s books reflect recordation of this note.

7. During all of the years subsequent to the issuance of the notes referred to above in paragraphs 2,4, 5, and 6 which were shown as held by NWT, taxpayer’s books reflected re-cordation of accrued interest payable thereon. No payments of interest were ever made by taxpayer on those notes.

8. On October 31,1956, the accrued but unpaid interest on notes shown on taxpayer’s books amounted to $3,648,819.58. On November 20, 1956, NWI’s board of directors adopted the following resolution:

WHEREAS, said Cuyuna Realty Company has operated at a deficit since its organization and, is hopelessly insolvent, and there is no possibility that it will ever be able to pay any part of said accrued interest, and
NOW, THEREFORE, RESOLVED,, that this Company gratuitously forgive, cancel and discharge the interest accrued up to and including October 81,1956, and unpaid 'on the $1,462,543.17 principal amount of notes of Cuyuna Realty Company owned by this Company, iu such manner and by such action as the President of this Company, in accordance with advice of counsel, may determine;
* iji # ❖ ❖
RESOLVED, that the President of this Company be and he is hereby authorized and directed to prepare and submit to this Board a plan for the recapitalization or reorganization of Cuyuna Realty Company with a view to the reduction of its interest of this Company and its stockholders.

9. On November 29, 1956, a plan of recapitalization for taxpayer was formally adopted by NWPs board of directors. On December 21, 1956, taxpayer was recapitalized pursuant to the plan adopted on November 29, 1956, and the notes referred to in paragraph 8, above, were canceled. Taxpayer’s balance sheet on December 21, 1956, showed the following:

Prior to Recapitalization
Assets
CO 00 00 rt*-co co üi oo C71 OO *<f 00 I — 1 CL <D Ti <D a.
Bonus — Whiteside Lease_ Advance royalties — Whiteside Lease. 8, 687. 15 33, 090. 05
Total Assets_ 1, 578, 605. 03
Liabilities and Net Worth
Liabilities Accrued interest payable. - Bills payable_ Advances payable-$11, 816. 99 1, 462, 543. 17 2, 071, 099. 34
Total Liabilities_ 3, 545, 459. 50
Net Worth Capital Stock — Common, 100 shares, $100.00 par value, issued and out-standing_ $10, 000. 00 Paid-in surplus_ 3, 648, 819. 58 Earned surplus_ (5, 625, 674. 05)
Total capital and surplus_ (1, 966, 854. 47)
Total Liabilities and net worth_ 1, 578, 605. 03

10. During the years 1952-1955, NWI did not report income from the notes referred to in paragraphs 2, 4, 5 and 6, above. During 1956 NWI reported as income only the interest which accrued on those notes from November 1, 1956 to December 21,1956.

11. Plaintiff, in preparing its tax returns, took deductions for the interest accruals and reported in its Federal income tax returns for the years 1952-1956 net losses as follows:

INTEREST CLAIMED PER TAX RETURN OTHERINCOME NET LOSS RE-ON DEBT OW- AND (EX- PORTED PER YEAR ING TO NWI PENSE) NET RETURN
1952_ $86, 192. 59 $5, 042. 25 $81, 150. 34
1953_ 86, 192. 59 4, 656. 00 81, 536. 59
1954_ 86, 192. 59 5, 049. 50 81, 143. 09
1955_ 86, 192. 59 5, 006. 48 81, 186. 11
1956_ 83, 644. 09 7, 844. 75 75, 799. 34
Total_ 428, 414. 45 27, 598. 98 400, 815. 47

Plaintiff’s returns for the years 1952-1956 were not audited, and its treatment of such interest deduction in its returns for those years was not disturbed by the Commissioner. It is not shown whether plaintiff’s returns for years prior to 1952 were ever audited.

12. In its Federal income tax returns for the years 1957 through 1960, plaintiff claimed net operating loss carryover deductions from the years 1952 through 1956, as authorized by Section 172 of the Internal Revenue Code. The net operating loss carryover was the result of accrual of interest on indebtedness to NWI. Upon audit of plaintiff’s returns for the taxable years 1957 through 1960, the Commissioner of Internal Revenue disallowed the net operating loss carryover deductions on the ground that the interest accruals upon which they were based were improper.

13. A tax deficiency plus deficiency interest was assessed against plaintiff and on April 8,1968, plaintiff paid into the Treasury of the United States the following amounts for the following calendar years:

TAX DEFICIENCY DEFICIENCY INTEREST YEAR PAID PAID TOTAL
1957_ $42, 074. 80 $12, 719. 29 $54, 794. 09
1958_ 21, 664. 99 5, 249. 46 26, 914. 45
1959_ 23, 666. 15 4, 314. 37 27, 980. 52
1960_ 45, 128. 10 5, 519. 23 50, 647. 33
Total_ 132, 534. 04 27, 802. 35 160, 336. 39

14. Plaintiff filed with, the District Director of Internal Revenue, St. Paul, Minnesota, on or about August 8, 1968, timely claims for refund for each of the years 1957-1960 on Form 843.

15. Plaintiff’s refund claims were formally disallowed by the Commissioner, whose statutory notice of rejection was duly mailed under date of November 14, 1963. This suit is timely brought.

16. Plaintiff is the sole owner of the claims here relied upon, and no assignment or transfer thereof or any interest therein, has been made.

17. No action on these claims has been taken by the Congress of the United States, or by any department of the Oovemment except as hereinbefore set forth.

CONCLUSION 03? LAW

Upon the foregoing findings of fact, which are made a part of the judgment herein, the court concludes as a matter of law that the plaintiff is not entitled to recover and the petition is, therefore, dismissed. 
      
      This ease was referred to Trial Commissioner C. Murray Bernhardt, who prepared an opinion and findings of fact. We have adopted the statement of fact portion of his opinion and his findings of fact without change. We arrive at the same result via a similar route.
     
      
      
        Campbell v. Carter Foundation Production Company, 322 F. 2d 827, 831 (5th Cir. 1963).
     
      
      
        John Kelley Co. v. Comm’r, 326 U.S. 521 (1946).
     
      
      
        Cf. Kraft Foods Co. v. Comm’r, 232 F. 2d 118 (2d Cir. 1956).
     
      
      
         John Kelley Co. v. Comm’r, supra.
      
     
      
      
         Arlington Park Jockey Club v. Sauber, 262 F. 2d 902, 905 (7th Cir. 1959).
     
      
      
        Affiliated Research, Inc. v. United States, 173 Ct. Cl. 338, 351 F. 2d 646 (1965).
     