UNITED STATES v. MISSISSIPPI CHEMICAL CORP.
Legal provision: Internal Revenue Code
Argument of Matthew J. Zinn
Chief Justice Warren E. Burger: Next in Number 52, United States against Mississippi Chemical Corporation.
Mr. Matthew J. Zinn: Mr. Chief Justice and may it please the Court.
This Federal Income Tax case is hereon writ of certiorari to the Court of Appeals for the Fifth Circuit.
It raises the question whether farmer cooperative associations like the respondents which are required to purchase the Class C stock of the New Orleans Bank of Cooperatives as a condition to borrowing from the bank may deduct the cost of such stock as interest expense or as an ordinary necessary business expense.
In New Orleans, Bank for Cooperatives is one of 12 regional banks which together with the Central Bank here in Washington were created by Congress in 1933 to furnish credit to farmer cooperatives at the lowest possible cost.
The bank’s original capital was furnished by the United States but under a Congressional plan embodied in the Farm Credit Act of 1955, the government capital was to be replaced gradually by capital belonging to member-borrowers which would purchase Class C stock.
The ultimate goal of the statute was complete borrower ownership of the banks.
The banks' authorize capital consists of three classes of stock, A, B, and C, each with a par value of a $100.00 a share.
Class A stock represents the government’s initial contribution to capital is nonvoting, pays no dividend and is to be retired at par with the retirement proceeds coming from borrower contributions to capital and the banks’ earnings.
Class B stock is intended for sale to the public.
It is issued at par, is nonvoting and may pay a noncumulative dividend not to exceed 4% a year.
After all, Class A stock has been retired; Class B stock may then be retired at par, the oldest Class B stock to be retired first.
Class C stock is the voting common stock of the banks.
It may normally be issued only to farmer cooperatives at its par value of a $100.00 a share.
Farmer cooperatives may acquire Class C stock in four ways.
First, each must purchase at least one share of Class C stock to be eligible to borrow from the bank.
Each of the respondents purchased the so-called qualifying share and capitalized its cost.
The capitalization treatment of the so-called qualifying share is not here in dispute.
Second, each borrower must invest quarterly in Class C stock, an amount equal to at least 10, but not more than 25% of the interest and payees to the bank on its loan during the calendar quarter.
The percentage requirement of the New Orleans Bank during the year’s here at issue was 15%.
It is the proper treatment of the cost of the Class C stock purchased under the 15% requirement that is herein dispute.
The respondents contend that they may deduct in addition to the stated interest on their loans, the cost of Class C stock in excess of a nominal value of a dollar share.
They contend that this is deductible as interest or as ordinary necessary business expense.
Justice William J. Brennan: Mr. Zinn, this is a stock that pays no dividends, right?
Mr. Matthew J. Zinn: It pays no dividends.
That is right Mr. Justice.
Justice William J. Brennan: Actually with those stock certificate is that --
Mr. Matthew J. Zinn: That is correct, Mr. Justice.
Justice William J. Brennan: It is just bookkeeping, is it?
Mr. Matthew J. Zinn: That is correct Mr. Justice.
The situation is much the same as it was in the Lincoln Savings case where there were no stock certificates.
Justice William J. Brennan: And this is not –- it is not transferable just like the Lincoln case?
Mr. Matthew J. Zinn: Just like in the Lincoln Savings case, it is precisely that, no transfer.
Justice William J. Brennan: This stock (Inaudible)?
Mr. Matthew J. Zinn: Yes, it does.
Our position Mr. Justice is however that even though there is no stated return on the stock, that the farmer cooperatives do indeed on the return in that they have a right to share in the profits of the year in which they purchased stock.
Justice William J. Brennan: And how do they share?
Is that simply by an (Inaudible) to bookkeeping?
Mr. Matthew J. Zinn: Well in the first instance, that is the third way in which they acquire stock Mr. Justice Brennan.
At the end of each year, each farmer cooperative gets what is called the patronage refund and then it initially issued in the form of Class C stock.
The patronage refund stock is distributed to farmer cooperatives in the proportion that the interest paid by each cooperative is --
Justice William J. Brennan: Now, when you say this distributed, how is it allocated?
Mr. Matthew J. Zinn: It is allocated on the books.
That is the same situation as it was in Lincoln where the credits to the secondary reserve.
Justice William J. Brennan: How does the farmer cooperative ever realize on this bookkeeping idea?
Mr. Matthew J. Zinn: The way it realizes it perhaps I can refer the Court to the graph on page 163 of the record.
It shows a revolving wheel and the farmer cooperative puts in its dollars at the top of that wheel and gradually as subsequent borrowers make investments in Class C stock.
After the government’s capital has been retired completely, and the Class B stock has been retired completely, the Class C stock whether purchased or issued as a patronage refund is revolved out on the cooperative principle of retiring first the oldest contribution.
Now to give you some idea of what is involved here Mr. Justice Brennan, let me refer you to page 8 of our opening brief.
There are several in this case.
We set out there in figures for the Class C stock purchased; the patronage dividends and the allocated surplus credits received by each farmer cooperative here -– each of the respondent cooperative.
Now, let us just take Mississippi Chemical for 1961.
They paid in $18,940.00 in change for Class C stock.
Now, that money presumably was used to retire Class A stock or Class B stock or earlier issued Class C stock.
And the same how they received a patronage dividend in the form of the Class C stock bookkeeping entry of $27,000.00 and they also received an allocated surplus credit of some $12,000.00.
The way this thing works is that at some future time after enough later people have purchased Class C stock they are going to get back not only the 19,000.00 that they came up with at the outset but the total of those three numbers in that line which is just under $59,000.00.
Unknown Speaker: And they get that back in cash?
Mr. Matthew J. Zinn: Yes, cash in hand at an indefinite future time.
I have already referred --
Justice Potter Stewart: That is all.
That is the absolute ceiling, is it not they --
Mr. Matthew J. Zinn: Yes, it is.
Justice Potter Stewart: It is only for that year?
Mr. Matthew J. Zinn: That is right Mr. Justice but we see no reason why an ordinary corporation could not instead of allowing stock to share in the profits of the corporation for all years which is the way it works in an ordinary corporation.
Justice Potter Stewart: So you get the profits of the corp -- they issue the profits of the corporation (Voice Overlap) in the year you bought a share?
Mr. Matthew J. Zinn: Right and --
Justice Potter Stewart: That is all what boils down to?
Mr. Matthew J. Zinn: And it is proportional.
That is exactly what it comes down to and it is proportional to the stock purchased in that year because of the cooperative mechanism.
The statute does provide for an allocation in terms of the interest paid by each cooperative to the interest paid by all, but the stock is purchased in the same proportion and the respondents’ contention is that we should not decide this case by reference to cooperative principles because it is perfectly clear that this is the provision of capital from the bank.
And if that were recognized this would be a nondeductible capital contribution and what we are saying is simply this that if they do not want the case decided on the basis of cooperative principles under which we clearly prevail, we look at the substance of the thing, the substance is that you are sharing the bank’s profits for that year.
Justice Byron R. White: And if you use –- if you borrow money every year you are sharing the profits of the year?
Mr. Matthew J. Zinn: Exactly.
Chief Justice Warren E. Burger: What does this –- What is the impact of this on the cost of renting or borrowing the money?
Mr. Matthew J. Zinn: Well, Mr. Justice, under the statute.
I will refer the Court to the first page on appendix B to our brief.
Chief Justice Warren E. Burger: Of your main brief?
Mr. Matthew J. Zinn: Of our opening brief, I am sorry.
That is on page 47.
During the years herein issue, the statutory limit, the stated interest was 6%.
Chief Justice Warren E. Burger: I am not sure, I am following you, 6%?
Mr. Matthew J. Zinn: 6% stated interest was the most that any bank could charge.
Now if you have to pay, come up with 15% of that to purchase Class C stock, that would raise the 15% of 6% as nine-tenths of 1%.
So that would be the effective rate.
Does that answer your question Mr. Chief Justice?
Chief Justice Warren E. Burger: Well, I think so.
I think so.
You were about to supplement your answer to Justice White, I think when I questioned you?
Mr. Matthew J. Zinn: Well, yes.
I was about to say when we say if you borrow every year, so long as your borrowing is outstanding Mr. Justice, you do not have to make a new loan each year.
You have to pay 15% of the interest each (Voice Overlap) year that you borrow.
Justice Byron R. White: Any year that you borrow the money?
Mr. Matthew J. Zinn: Right, you share on the profits.
Justice Byron R. White: How would you pay something?
You pay an override on the interest, you can underwrite back?
Mr. Matthew J. Zinn: Well, we do not use those terms because we do not find them in the legislative history, the respondents do.
The legislative history refers to these as investment and patronage refunds and we will stick with those statutory terms.
The position of the respondents here is that all they got was the right to receive the money they paid in at some indefinite future time.
Now, we think we have already shown that they got more than that if they got the right to receive that money back in cash and also got the right to receive the profits of the year in which they made the purchase.
But our position here does not turn on whether there is a retirement or not.
In the last brief which we filed in October, we attempted to respond to the respondent’s contention that there exists a universal principle that if as a condition to a loan, a borrower is required to purchase an asset at more than its fair market value, the excess is deductible interest.
We attempted to dispute the assertion of that universal principle by putting the hypothetical of a case in which a borrower goes to a commercial bank and asks to borrow $10,000.00 for 10 years and the bank says very well, we will loan you $10,000.00 for 10 years at a stated interest rate of 8%.
But as a condition to that loan, we are going to ask you to keep on hand in a non-interest bearing checking account $1,000.00 during the term of the loan.
We say in that case that only $800.00 is deductible interest.
Now, the fair market value of that compensating balance may be zero.
It may be that there is no market for restricted compensating balances.
Nonetheless, we say it is clear that you cannot deduct the whole $1,000.00 because you still own it.
The present value of the $1,000.00 compensating balance that is the right to receive $1,000.000 in 10 years, we assume to be $650.00.
Nevertheless, we urge that the $350.00 difference is not deductible interest.
It is simply interest that they might have earned, but did not earn and they might have earned it had they been free to invest the $1,000.00 at a growing rate of interest for the 10-year period rather than a non-interest bearing checking account.
For this latter proposition, we relied on this Court’s decision 30 years ago in Hort against the Commissioner in which the Court held that no deduction is allowable or income that might have been but was not earned.
In the paper which respondents filed last week, they now can see that only $800.00 is deductible interest in that hypothetical.
Under their analysis, the borrower in the hypothetical really borrowed only $9,000.00 and so they say the proposition which they originally asserted that whenever a borrower is required to purchase an asset at more than its fair market value, the excess as deductible interest remains intact.
We disagree and we submit that by conceding the hypothetical, respondents have conceded this case.
Let me put a second hypothetical to the Court.
Instead of having to pay in to the checking account $1,000.00 at the outset, the borrower has to pay only $100.00 at the outset, but on each succeeding anniversary of the loan, must also pay $100.00.
Under respondents’ analysis, the amount of the outstanding loan during the first year would be $9,900.00.
The amount during the second year would be $9,800.00.
The amount during the third year would be $9,700.00 and so on, so that on the tenth year, the amount outstanding on the loan would be $9,000.00.
The average balance over the 10-year period would be $9,450.00.
Nonetheless, no more than $800.00 would be deductible as interest in any of those years.
If $1,000.00 based at the outset is not deductible as respondents now concede, a fortiori a $100.00 placed each year is not deductible.
It is no more fictional to say in this second hypothetical that the amount of the outstanding loan was reduced gradually to $9,000.00 than it is to say that the amount of the loans reduced gradually or reduced in the first instance to $9,000.00 in the hypothetical put in our reply brief and neither of those cases is this case.
But let me move matters somewhat closer to home.
Take the same facts as in the second hypothetical except that instead of being required to keep the compensating balance on hand for only the term of the loan 10 years, the borrower has to keep the compensating balance on hand for 13 years.
Under respondents’ analysis, the borrower has borrowed $9,000.00 for 10 years or $9,450.00 in the periodic payment case and has had to leave on deposits for three additional years in a non-interest bearing checking account of $1,000.00.
The fourth case tells us that interest that they might have earned on that checking account, had it been invested at the growing rate of interest instead of a non-interest bearing account.
It is not the deductible.
Finally, let me move to the last hypothetical which I think approximates this case.
It is the same as the facts in the third hypothetical except that instead of the banks agreeing to release the compensating balance at the end of 13 years, the release is to be made at an indefinite future time.
This in effect is the situation in the instant case, on the respondents’ assumption which we do not agree with that purchased Class C stock earns no return that it has on other value to respondents.
In other words, that gives the respondents only the right to get their money back at some indefinite future time.
Now, here just as in the third hypothetical what the borrower has foregone is simply the interest income that he might have earned from the end of the tenth year, until the indefinite future time that will receive its money back.
Justice Byron R. White: Could you –- I gather the government does not give up even that much?
Mr. Matthew J. Zinn: That is right.
We say that it is getting a return.
We say that --
Justice Byron R. White: Let us assume that over a period of five years, that a loan lasts over five years or there have been several loans in the five-year period And there have been very -- each year there has been allocation of Class C stock to the borrower?
Mr. Matthew J. Zinn: Right.
Justice Byron R. White: And then the borrower does go bankrupt?
Mr. Matthew J. Zinn: Oh in that case --
Justice Byron R. White: And there is a balance holding, is the Class C stock allocable to the loan?
Mr. Matthew J. Zinn: The banks are empowered to possess the face amount of Class C stock against the face amount.
Justice Byron R. White: Is the borrower-Class C stockholder legally entitled in that --?
Mr. Matthew J. Zinn: Legally entitled?
Justice Byron R. White: Yes?
Mr. Matthew J. Zinn: No, it is in the discretion of the banks, but nonetheless at some future time, it will come back.
Now, I think what you are referring to Mr. Justice, the respondents’ intimate that the bank may never retire the Class C stock.
So they will never get their money back.
It is true that there is discretion here as to the exact time and --
Justice Byron R. White: But that is their duty as to when?
Mr. Matthew J. Zinn: That is right, as to when and really in this case that argument is wholly unfitting because after all we are talking about instrumentalities of the United States and the only way that can achieve the purpose that Congress has put forth here is to allow foreign cooperatives to own the bank entirely and to allow those who borrow from a cooperative bank to own this.
And these purposes can only be achieved if the Class C stock has rolled over.
They will not be achieved if the Class C stock is never redeemed.
Furthermore, if we are talking about a situation where the 13 people who are on the Federal Farm Credit Board are very responsible officials.
12 are appointed by the President of the Untied States with the advice and consent of the Senate.
They are nominated by the farmers and the Farmer Cooperatives itself.
Well, thirteenth member of the Federal Farm Credit Board is appointed by the Secretary of Agriculture.
Now as far as the Board of Directors of these individual banks, six of them, six out of the seven are elected by farmers and Farmer Cooperatives.
The seventh is appointed by the governor or the Farm Credit Administration.
We agree that there is discretion as to timing, but we say that there is little doubt here, that the stock eventually will be redeemed and that even on respondents’ assumption that they are only getting the right to get their money back, there is no deduction based on the four hypotheticals that I have put to the Court.
Mr. Chief Justice, I should like to reserve my remaining time for rebuttal.
Chief Justice Warren E. Burger: Very well.
Argument of John C. Satterfield
Mr. John C. Satterfield: Mr. Chief Justice and may it please the Court.
In this case, we have a very basic difference of opinion with the government in its position.
In order for the government to prevail as has been indicated by counsel, they must establish this proposition which appeared on page 11 of their brief 15 is taken to all grand position on the case, neither the fact that respondents are required to invest in Class C stock in connection with their loans.
Now the limitations on transferability of the stock could convert its cost into a deductible expense.
If it otherwise would qualify as an income-producing asset providing benefits in 50 years.
Our position is and I will demonstrate that this is not an income-producing asset, that in fact it has only a nominal value or as the Fifth Circuit Court of Appeals held while it is not worthless using the words of that Court, it was without an appreciable market value and had only a nominal value.
As said again by that Court, Class C stock shares are of no appreciable value to the taxpayer.
As said further in that Court, the Class C shares had no fair market value and no more than a nominal value and no value to the taxpayers “in the usual sense.”
Now, reference had been made by counsel both in the brief and in argument, taking the position that the patronage refund is credited upon the books as Class C stock and allocated surplus credited upon the books as a Class C stock, were credited upon and earned by the amount paid as interest override or for purchase of so-called of Class C stock.
Now, as a matter of fact that is wholly without any foundation and the statute and the regulations, in law or in fact.
The statute provides in Section 1134 (g), all patronage refund shall be paid in proportion the amount of interest earned on the loans of each borrower bears to the total interest earned on the loans of all borrowers during the year.
It has no relationship to the free interest made at the end of the year, qualify C stock to with one interest, the amount paid as interest override on the Class C stock column, another entry on the patronage refund as Class C stock on the column, another entry as allocated surplus on the Class C stock column.
And the Regulation 70 part 162 which appear on page 65 of the brief as an appendix of the government, allocation shall be made in what?
They are wholly unrelated to this, it is just override itself.
Allocation shall be made in proportion that the amount of interest accrued on the loans of each borrower bears to the total interest accrued on the loans of all borrowers during the fiscal year and shall be recorded as allocations at the end of the fiscal year.
It is impossible to conclude that the interest made as patronage refunds, allocations of surplus are returns upon the interest made at the end of the year of the interest override amount on the so-called Class C stock.
Let us take an illustration as to what this really means.
These Class C stocks are in either in that year or in subsequent years any income.
Cooperative “A” has accumulated a $150,000.00 in par or face value of Class C stock.
Cooperative “B” has just come in and bought one qualifying share of Class C Stock on the basis of $100.00.
Each borrows from the New Orleans Bank for Cooperatives that is the same amount of money, their loans are identical now.
The cooperative with $150,000.00 in par value of Class C stock, the cooperative with the $100.00 par value of Class C stock received the identical amount of patronage refund, the identical amount of allocated surplus, the same being related not to Class C stock or to interest override.
It is related to the interest paid upon the loan for the year.
That is true both as to the first year and as to every subsequent every year.
So that as a matter of fact it is impossible that this can be attributed to it.
Now, this has been recognized by the government in this case, in the M.F.A case and in other cases.
In this case, that was included in the District Court an attempt to recover patronage refund.
The basis being that the patronage refund had a value which was a taxable value for basis of $100.00 per share.
The District Court held against the government on that.
In the Court of Appeals the government abandoned that position.
It did not appeal from the District Court to the Court of Appeals.
It has not appealed to this Court.
In the M.F.A. case, come to Eighth Circuit, it was not even involved in the District Court although it is one of the briefs it was indicated that it might have been involved.
But in the –- at the Court of Appeals level, it was not urged and now on the petition for writ of certiorari now pending.
It is not urged.
And why is that?
And mind you, this is all the same Class C stock.
No difference on one Class C and another Class C, all interest as suggested by indicated on the books.
Now why is it that we are not asked to pay tax on the Class C stock on the second column under the heading patronage refund?
Class C was made for Class C stock under the heading allocated surplus but only those interests may at the same time at the end of the year under first column Class C stock said to be resulting from the payment of interest overriding it.
Here is the reason.
In Rome and in Cafter, it was hereby the Fifth Circuit and the Fourth Circuit and in Regulation, Treasury Regulation 161-5-b-123 and 124, the IRS had taken the position that while this type of certificate or stock is issued and is received as patronage refund, the market value shall be taxed to the patriot at the time of the receipt and “the regulation,” this is taken all from those two decisions, “however, to the parts of this subdivision, any document which is payable only in the discretion of a cooperative association, shall be considered not to have any fair market value unless it is clearly established to the contract.”
Therefore, this Class C stock while that being 1, 2, or third column does not have market value unless it is clearly established as contrary and this record, as we have shown in our briefs, as were found by the Fifth Circuit Court of Appeals, as was found by the District Court, not only was not clearly shown to have value or market value it was clearly shown to have only a nominal value. That is a matter of discretion.
This illustration of the compensating balance is holding applicable.
If there is a compensating balance, it is repayable when the loan is repaid as kept by loan value on that.
It serves money.
What if it does not have as we pointed out in our supplemental brief?
If it is a $10,000.00 deal you have a compensation of about $1,000.00, you save for about $9,000.00.
Say upon 8% you pay 8.9% but the number of dollars is the same.
You pay $800.00 interest on a $10,000.00 loan but you deposit $1,000.00 you actually get $9,000.00.
Hence, you are paying 8.9% and you have a deduction for the full $800.00 paid and you do not ask for it or receive anymore.
But that is your money, it comes back to you and you receive it.
Now here, if or when, or how under what circumstances, Class C stock may be revolved is within discretion of three borrowers.
The market says it has recommendations to original Farm Credit Administration.
There are important credit administration recommendations to the Farm Credit Administration within all three discretions not to be exercised in order for it to be repaid.
Now, not only that but there has been some inadvertent errors or omissions in the brief which has been filed by the government in this case.
I think perhaps in receiving advice from the Farm Credit Administration their telephone –- it is just hard for telephone too soon.
For instance, there is a statement made is not in the record, no evidences are supplied whatsoever it is not -- but the statement is made that they have been advised by the administration, Farm Credit Administration, this is note number 26 on page 21 that all the A stock in your bank cooperative have been repaid.
But, and this is what (Inaudible) assumes, but what actually happen was the clear implication, is it was repaid by the revolving of C stock.
The fact is Bank of Cooperatives, borrowed several millions of dollars on open market in order to pay it off and now the effect of it rather hastening the repayment of C stock as a financial matter, it means it would be a longer period time before the C stock can be revolved because they are paying a higher interest and no matter they borrowed the A stock then they were paying returns to the government on the A stock.
Now, it is a fact that by borrowing that money, inviting themselves by that additional interest and inviting themselves with taxes in all its exempt, they have reduced their financial ability to repay C stock.
But they have removed the legal inhibition which existed because they could not revolve C stock as long as A was outstanding, but that is a situation which has not improved the possibility of the revolving of the C stock.
And it is to that, now, I mentioned only in facing another time in which (Inaudible) note number 16 –- Of the note, I am sorry, on page 7, this is note on page 21.
Some reference is made to the possibility that if this Court holds this – the taxable income there might be a $100 million less lending power for the Banks for Cooperative.
I say that it is kind of a point to assume, but as a matter of fact, if it should occur that on the other side of the coin that the banks, it should be held this is interest income to the bank.
The statute having additional interest income or margin, the statute requires that that be paid to their patron.
It is not taxable income.
It increases the amount of patronage refund which is deductible from the bank and from their taxable sources.
In addition to that, depending on the discretion of the bank and they have full discretion, it would not affect their lending power in any way.
If they, in their discretion simply said we would simply delay the revolving of the earliest C stock because we have a million dollars less or $500,000.00 less since this went out in patronage as additional margins.
Therefore there would be no burden of whatever upon the banks if that occurs.
Now, may I point out to the Court a few things, especially in connection with this Lincoln case?
Chief Justice Warren E. Burger: Before you get to that Mr. Satterfield, I would like to have your comment on analogy that Mr. Zinn suggested.
I think he pointed out that as he saw it, this situation was very much like a borrower going to a bank to borrow $10,000.00, if I followed his hypothetical correctly, and the bank said yes, we will lend you the $10,000.00 at 6% or whatever, provided you leave $1,000.00 at all times in a non-interest bank checking account.
Now, is he unduly over simplifying this transaction when he puts that analogy to us?
Mr. John C. Satterfield: May it please the Court, the answer is yes.
In that instance the $1,000.00 is placed in the account.
The actual $1,000.00 is repayable when the loan is repaid.
It is true that the borrower received $9,000.00 rather a net of $9,000.00, rather a net of $10,000.00 as a loan.
The only result is he paying a higher rate of interest because if he pays 8% on $10,000.00 that amounts to 8.9% on a $9,000.00 and there, there is no similarity to this situation at all because it is the money of the borrower.
It is repayable not in possible discretion depending on as I have listed in the brief at 11 contingencies it may or may not have, but it is fund.
It is money there belonging to the borrower.
Therefore there is no parallel to this case whatsoever.
It is simply in that case you see not that there is a lack by the taxpayer of claiming what he might have earned by the use of $1,000.00.
He has said he required to pay a higher rate of interest because it gets the $9,000.00 loan and he spent 8.9% interest by paying the same interest that he would have contracted upon $10,000.00, otherwise $8,00.00 is all the interest what he paid on $10,000.00 loan on 8%.
If he pays $800.00 a year on a $9,000.00 loan, he pays 8.9% and he has the right to deduct the full $800.00.
He does not deduct more, he does not deduct less.
He deducts what he pays.
Unknown Speaker: You would not concede (Inaudible) of deduction of $1,000.00 and the reason is I suppose it is $1,000.00, you think the amount is $1,000.00?
Mr. John C. Satterfield: Well as --
If you are saying that in your case, the point that you have plenty of class you divide it with Class C stock and get to the certificate, you say there is no one tell you at all?
Mr. John C. Satterfield: Well, has no value, it had only a number of that.
Unknown Speaker: (Inaudible) by that you have a $1,000.00?
Mr. John C. Satterfield: Right.
And it remains as in time instead of a loan; it is money belonging to the party involved, contingencies as to possible repayment in 28.1 years as the evidence shown in this case or 31 years in Penn Yan case so some other indefinite period of years does not exist.
It is his money, like in Lincoln case.
Now in Lincoln, as the Court will remember, there was a secondary result.
Now this secondary reserve in Lincoln, the money was deposited.
Now, under the statute there, there were the mandatory provisions as the Court said in discussing the effect, three instances in which the party would get the money back and was required to be paid the money back by the statute, said the Court in that case –- this Court on that case.
The prospective refund indicates an in cash effect of institution of pro-rata share upon culmination of its insured status or upon receivership or liquidation, or when the primary reserve alone reaches suspension level was required to be made by the statute.
In other words, if the primary reserve got big enough the guy got back what he put in the secondary reserve.
Now in addition to that, in that statute, there was income producing as a matter of fact because the statute required that the Home Loan of the Insurance Company (HLIC) pay interest upon the secondary reserve amounts in the identical percentages that they received from their obligations held by them with the Unites States government, and in the brief, filed by government in that case it was said without dispute that as a matter of fact, in the time involved in this particular case that there was earned from 3.15 to 4.43% annually upon the secondary reserve.
That was always there.
It was mandated to be returned under any or all circumstances which might occur.
Whereas in this case, this credit entered upon the books is (1) as to which the fund may or may not be repaid.
There is quite a difference between a legal right to receive by a depositing case with interest guaranteed by the statute or a right to receive back a compensating deposit with the bank with or without interest.
As compared to a situation in which we have this.
Now, what is this interest override?
The statute itself is clear.
The statute says in 26 U.S.C. 1134 (d) uses the words that the borrower shall be required to invest quarterly in Class C stock and of course as we said in Lincoln, so the statutory label of prepayment and advance premium contains 404 (d) are not controlled.
But as you call it, the purchase of Class C stock is not controlled.
The fact that was made is controlled.
It comes on to the old principle recognized by this Court since the beginning of taxation.
If the substance is not to fall the incisive substance, the incisive facts as distinguished from the form that are governing all tax matters.
Now, how about these amounts?
These amounts required to be paid which are here involved as the only, the first of the three kinds about this stock, that is so called interest override, an amount equal to not less than 10 not more than 15% of what, I am reading it from the statute now, “of the amount of interest payable by it to the bank during the calendar quarter, 8% of the interest thus is required to be paid.”
Now, this is right significant sentence seems to me, this is coming from the statute, “Payments for such stock shall be made quarterly and when the regular interest payments of the borrower are payable.”
There is no question about the regulating an interest fall.
Within regular interest of 6% at this time, period of time, let me spend remove we are now paying 7 or 8 regular interest, but we pay 15% more upon the regular interest.
Therefore, we do have a valid question, a matter of the payment of funds for what part?
Now, let us look at that just a minute.
Why was it paid?
That is the real question.
Why was these amounts paid?
Were they paid as investment?
Are we paying a $100.00 a share for the interest on the books so called Class C stock as an investment because we expected that it might be returned if the discretion was so exercised in 20.4 years or 21.6 years without interest, without dividends, without any earning?
Well, of course not.
The incisive practicality affects session required that it be determined.
Well, this taxpayer paid the $99.00 difference between the $100.00 so called par and the nominal value found by the Fifth Circuit in the District Court for the use of money or to buy an investment and I do no think there is any businessman in the United States would be foolish enough to pay a $100.00 to buy the so-called Class C stock which may in the discretion of free bodies, being paid by some unknown date if Congress does not change at all and if the bank does not decide to go ahead and pay taxes refund in some other matter.
Chief Justice Warren E. Burger: Mr. Satterfield, the Solicitor General made some argument with respect to note 8, I think on page 8, of his main brief in which he set up the cost of the Class C stock purchased and offset that with the patronage dividends and allocated surplus.
What -- you recall that --
Mr. John C. Satterfield: Yes, I do.
Chief Justice Warren E. Burger: What do you have to say about his contention on that score?
Mr. John C. Satterfield: May it please the Court, our position is this, that as is set forth in the statute itself, these preference dividends or refunds and allocated surplus are a participation in the margin of profits of the bank that they are arising from the payment of the -- as the statutory regular interest.
Now, this 15% is at the end of year, the statute so provides and so does 70.142 of the regulation.
So the interest upon which the government now says, we receive patronage refunds or receive allocated surplus, did not even exist during the year.
They will make at the end of the year at the same time that the patronage refund and allocated surplus were credited for one reason.
Chief Justice Warren E. Burger: Well, what is your theory of the impact of that patronage refund and the allocation on the cost of borrowing this money?
Mr. John C. Satterfield: That actually has a result if and when it is repaid 20 to 31 to 40 years later to the extent of the value of the money in 1958 which may be repaid by 1981.
To that extent, it will reduce the cost of the regular interest and also the interest override which have added to the regular interest.
It would reduce to cost to the extent of its value by $1.00 share.
Justice Byron R. White: Well, in your theory, if the Class C stock will ever repay that would be income to the borrower there?
Mr. John C. Satterfield: Yes sir, we believe and it is our position that if ever we are repaid, it would be ordinary income, taxable as ordinary income to the borrower and that may be 28 years or 31 years from now.
Chief Justice Warren E. Burger: In other words, you are saying, this is just an inchoate income, this $27,489.00 for 1961 is inchoate income that he may -- on which he may have to pay an income tax in some future year?
Mr. John C. Satterfield: Now, that is true.
It is merely a possibility and possibilities are not taxed and we have pointed out on page 7 of our brief and further on page 9 of our brief, eleven contingencies upon which depends the amount paid and on page 9 we pointed out seven contingencies or discretions which has to be exercised if it ever easily paid.
So seven and 11, 18 different elements that are into whether or not we will ever see the inchoate income which might come as a result of the interest which arose from actually not the entry of the first column at the end of the year.
So for interest over, whatever it may be called Class-C stock, but from the payment of the regular interest quarterly which were paid.
The interests of this under the regulations are made only at the end of the year.
Justice Lewis F. Powell: Mr. Satterfield, does Class B stock (Inaudible)
Mr. John C. Satterfield: To this extent Mr. Justice Powell, the Class C stock is subject to a lien securing any borrowing by the borrower, a loan by the borrower then (Inaudible), but the record shows on page 242 and 246, the testimony of the President of the bank un-contradicted this that under no circumstances is it ever given any collateral value.
He testified that if an application is made for a loan and if the balance sheet shows Class C stock by $100,000.00, they strike that out in arriving at the valuation or the security given.
It is never used as security to obtain a loan.
It is technically liable to a lien of the repayment below.
The bank has never sold a single share of Class C stock all of them under compulsion of the statute.
The testimony shows that unlike the situation in M.F.A., that there has never been a sale from one cooperative to the other of new cooperative stock, the situation being fine severe or different.
Justice Byron R. White: Has there ever been a failing borrower?
Mr. John C. Satterfield: Yes, there have been failing borrowers.
Justice Byron R. White: And presents to you about this Class C balance?
Mr. John C. Satterfield: If in those instances there was the Class C balance, they would credit up to the balance who would not pay one nickel on what was left over?
Justice Byron R. White: Other than that?
Did they –- did the bankrupt creditor or bankrupt borrower get his loan reduced by the amount of the Class C balance?
Mr. John C. Satterfield: Only to the extent that it was required to balance all of the loan if it was sufficient.
Justice Byron R. White: (Inaudible) dollar for dollar in the Class-C stock --
Mr. John C. Satterfield: If it was required to pay the balance, otherwise not.
In other words --
Justice Byron R. White: So the answer is yes?
Mr. John C. Satterfield: Oh well --
Justice Byron R. White: In the actual instance you --
Mr. John C. Satterfield: Mr. Justice in the instance, I am talking about that, it have to be no because in that instances that were in the record, there was an insolvency.
There was Class C stock which would balance all of what was left and additional Class C stock.
All “owned by the borrower” which was not balanced of.
Now, this additional Class C stock “own by the borrower” was canceled.
He got no money.
Justice Byron R. White: I understand that but his loan was paid of?
Mr. John C. Satterfield: Yes, if there was an opportunity.
Justice Byron R. White: (Voice Overlap) Months ago, the bank did not attempt to collect from the bank any of it all?
Mr. John C. Satterfield: To the extent that it might be --
Justice Byron R. White: Except by setting of the –- Except by reducing the Class C balance?
Mr. John C. Satterfield: Right, in other words, it was used to balance to the extent it was available.
Well, may it please the Court we like to close in pointing out this fact.
And that is that the real and only issue in this case is whether these payments of 15% of the regular interest were made for the use of money because of the need of use of money in order to obtain unused money.
It was not made as an investment to obtain a capital income-producing asset.
I concede only one answer.
They were made under compulsion of statute.
They were made in order to obtain and retain the loan.
May I call the attention of the fact this intrinsic value argument has no substance whatever.
This, unlike the home loan bank situation in (Inaudible), one share, the qualifying share a $100.00 are paid par value, part of the constraint they issued the $100.00 when they got the fair share qualifying into the said loan.
But as they received that, it made no difference with how much stock they had.
They only have one vote.
They got that vote in 1956 in MCC in 1957 “and all the stock that is involved in this suit did not give them another vote, did not give them any additional eligibility for loan, did not give them any additional right to call on the bank for services, it did not give them any fact, accept that.
Perhaps in the discretion of these parties, they might receive what?
The amount they had paid back in 20.1, 21.2, 17.1 year and the records of the government to 14 years is without any basis or facts whatever.
Chief Justice Warren E. Burger: Thank you, Mr. Satterfield.
You have ten minutes Mr. Zinn.
At some point in here, would you comment on Mr. Satterfield’s comment on your footnote 8 argument?
Rebuttal of Matthew J. Zinn
Mr. Matthew J. Zinn: Mr. Chief Justice and may it please the Court.
We believe that there is a return on this investment.
Mr. Satterfield has addressed the fact that the statute provides for the allocation of each year’s profits on the basis of the interest paid by one cooperative to the interest paid by all and that is what the statute provides.
But stock is purchased in the same proportion that interest is paid and the statute might as well have provided that the return is payable in accordance with the ratio of the stock purchased by each cooperative, so the stock purchased by all for the profits of that one year.
Now, this is different from the division of profits in an ordinary corporation.
If you buy stock in an ordinary corporation, you are able to share in the profits of all years.
In this situation, you are able to share in the profits of only a single year.
As I mentioned too earlier however, it should not make any difference.
There is no reason why an ordinary corporation could not issue securities of the same type.
The fact remains that at the end of the period, whenever that indefinite time when the Class C stock is revolved, that these people put in $19,000.00 in 1961, they are going to get back $59,000.00 whether it would be 14 years later or 30 years later, it is of no consequence.
They are going to get it back.
Interest, Mr. Chief Justice is not something that you own, a divisible interest that you own and that you get back.
You do not get interest back and this is not interest.
It was the same situation in Lincoln.
It was a kind of insurance even though the only reason it was paid into the secondary reserve was to get car insurance.
You got it back.
Chief Justice Warren E. Burger: As I understand Mr. Satterfield’s argument though he said, I think in response to a question from Justice White that whenever this windfall, this return comes, it will be taxable in this ordinary income.
Do you agree with that?
Mr. Matthew J. Zinn: We will accept that Mr. Chief Justice.
We will accept that if that is his representation.
Justice Byron R. White: (Inaudible) But you would not say that?
Mr. Matthew J. Zinn: That is ordinary income?
I am not sure I understand.
Justice Byron R. White: In your case, it does say it was (Inaudible)
Mr. Matthew J. Zinn: Yes.
In addition attempting to show that the stock does not substance bear return Mr. Justice to the four hypotheticals, I attempted to show that even if bears no return and that it –- even if it gives the respondents only the right to get their money back at an indefinite future time there is still no deduction.
What the respondents are seeking to deduct here is interest income that they might have earned, had they been able to invest their money.
Chief Justice Warren E. Burger: Well, this brings you back to your analogy of the $1,000.00?
Mr. Matthew J. Zinn: Yes.
Chief Justice Warren E. Burger: Non-interest bearing checking account, but it does not make any difference whether you get it back in one year, you are saying to us now of four years?
Mr. Matthew J. Zinn: Or ten years.
That is right or 13 years or 20 because under their analysis you borrowed $9,000.00 for 10 years.
Now what you are left with, you have a $1,000.00 on deposit after that, you do not earn interest.
If you have it invested at interest-bearing account, you would have earned interest.
But in Howard against the Commissioner 30 years ago, this Court held that income that you might have earned and did not is not deductible and the respondents do not challenge the Howard case.
We cited it in our brief and they do not ask the Court to overrule it.
Unknown Speaker: But if I borrowed to this bank this year, I have to pay a $1,000.00 and to buy Class C stock because I placed that much interest?
If and then I get that particular Class C stock (Inaudible)
Mr. Matthew J. Zinn: The $1,000.00 you purchased?
Now, I would like to make one final point.
Yes sir Mr. Justice.
Justice Lewis F. Powell: Mr. Zinn, if I may come back to your response you made a moment ago.
Did I understand you to say that if the $99.00 is ever paid back to the cooperative, then it would be adjoined as a ordinary income?
Mr. Matthew J. Zinn: The $99.00?
Justice Lewis F. Powell: That is allocated?
Mr. Matthew J. Zinn: That is deducting?
Justice Lewis F. Powell: The Class C stock.
Mr. Matthew J. Zinn: That is allocated?
Justice Lewis F. Powell: That is allocated to the Class C stock and which is at issue in this case?
Mr. Matthew J. Zinn: On the assumption that they win this case or lose it Mr. Justice?
Justice Lewis F. Powell: On the assumption that sometimes in the future, there is a distribution on the Class C stock?
Mr. Matthew J. Zinn: If the government prevails in this case and we would not attempt to tax the $100.00 that they will be getting back.
We would attempt to tax the amounts in two and three on page 8.
Justice Potter Stewart: The first $100.00 would be returned as capital?
Mr. Matthew J. Zinn: Exactly.
Unknown Speaker: But the patronage dividend and the allocated surplus you would not tax?
Mr. Matthew J. Zinn: That is right.
As ordinary income.
Unknown Speaker: Alright.
Mr. Matthew J. Zinn: Now, one final --
Chief Justice Warren E. Burger: And you say I suppose, if I may interrupt once more, in response to Mr. Satterfield’s point about this being 30 or 40 years from now, that they knew that when they made the contract and borrowed the money, and it is part of the contract?
Mr. Matthew J. Zinn: Exactly.
And I think we pointed out in our brief, that even if it was 30 years and without regard to the allocated surplus credit, there would still be a return of the slightly more than 3%.
While in Lincoln, it was between 3.15 and 4.75% at the time on investment.
But we do not –- as I say, I want to stress we do not rely exclusively on the fact that this has to be interest-bearing.
We say, even if the Court views it as merely the right to get your money back, that under the four compensating balance hypotheticals that I referred to in my opening remarks, they are trying to deduct income that they might have earned, but did not and --
Unknown Speaker: And if the only way to get the money back it depends on (Inaudible)
Mr. Matthew J. Zinn: Well, that is true and in the case of any investment in a common stock, you only get your money back if the entity is successful.
Unknown Speaker: (Inaudible)
Mr. Matthew J. Zinn: Exactly, that is the way we described it in our brief that at the end of the year, you know you are going to get that $59,000.00 and you pay $19,000.00 for that certificate and in the Midland-Ross case, Mr. Justice Brennan writing the opinion for the Court, held that that differential was ordinary income.
One final point, the Court in the Lincoln Savings Case, not only discussed the secondary reserve, but also the Federal Home Loan Bank Stock that Savings and Loan Associations are required to purchase in order to be members of the Local Federal Home Loan Bank and the Court said, certainly, the FHLB Stock is an asset and its acquisition is capital in nature that is in 403 U.S. 356.
Mr. Justice Blackmun’s statement there is not qualified by whether you get or return or not get a return on FHLB Stock.
He recognized that, that is an asset, a nondeductible cost because it was a provision of capital for the Federal Home Loan Banks.
It provided as he pointed, requited the unavailability of loan funds.
Now, that is precisely the function of the contributions to capital that we are concerned with here.
They provide liquidity and availability of loan funds.
Now, the fact of the matter is that certain Federal Home Loan Banks throughout the higher 1960s pay the return of roughly 13.75%.
Now, the going rate of interest during the 1960s are presumably was more than 13.75% and nonetheless, there is no room for the argument that any portion of the contribution to the Federal Home Loan Banks capital is deductible because if they invested their money elsewhere, they might have gotten 5% or 10%.
But that is the respondents’ argument in this case.
They even say that the Lincoln case is going to be back here next term because they say that –- well, let us say if Lincoln got 4%, if Lincoln, if the going rate of interest was 8%, they say that in the fair market value, the contribution to the secondary reserve therefore was only 50% of the amount paid.
They say that Lincoln is entitled to deduct the other half as an ordinary expense.
That this Court really did not resolve the secondary reserve problem last time and we say that is inadmissible because there is other value except value in the marketplace and the Court recognize that other value at 403 U.S. 356.
That is all I have.
Chief Justice Warren E. Burger: Thank you Mr. Zinn.
Thank you Mr. Satterfield.
The case is submitted.