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March 2, 1964


Author: Hastings

Before HASTINGS, Chief Judge, and KNOCH and KILEY, Circuit Judges.

HASTINGS, Chief Judge.

Taxpayers'*fn1 petition for review of eight decisions of the Tax Court of the United States determining deficiencies in the tax due from them in the total amount of $285,306.98. T.C. Memo. 1962306. The cases were consolidated for trial and for the purposes of this review.

The facts in each of the cases are substantially identical, except for the amounts involved. On this review it shall be sufficient to consider the facts referring to Louis H. Lewis.

We are concerned with the tax years 1955 through 1959.

The decisions of the Tax Court were based on its conclusions that:

(1) certain amounts claimed as interest deductions in 1955 and 1956 arising out of loans incurred to purchase United States Government securities were not deductible;

(2) taxpayers' out-of-pocket expenses or losses incurred in such securities transactions were not deductible; and

(3) amounts claimed as expenses of borrowing securities in 1957 and of carrying a short position during 1957, 1958 and 1959 were not deductible.

On this review, no appeal is taken from that portion of the Tax Court's decisions disallowing the deductions claimed for interest expenses. This holding appears to be well established by an unbroken line of decisions. Regardless of a taxpayer's motives, where a paper transaction lacks substance and no genuine indebtedness is created resulting in a bona fide debtor-creditor relationship, no interest can be said to have been paid for the use or forbearance of money actually loaned and no interest expense deduction may flow therefrom. Bridges v. C.I.R., 4 Cir., 325 F.2d 180 (1963); Salley v. C.I.R., 5 Cir., 319 F.2d 847 (1963); Nichols v. C.I.R., 5 Cir., 314 F.2d 337 (1963); Rubin v. United States, 7 Cir., 304 F.2d 766 (1962); MacRae v. C.I.R., 9 Cir., 294 F.2d 56 (1961), cert. denied, 368 U.S. 955, 82 S. Ct. 398, 7 L. Ed. 2d 388; Kaye v. C.I.R., 9 Cir., 287 F.2d 40 (1961); Becker v. C.I.R., 2 Cir., 277 F.2d 146 (1960); Lynch v. C. I.R., 2 Cir., 273 F.2d 867 (1959); Goodstein v. C.I.R., 1 Cir., 267 F.2d 127 (1959); Broome v. United States, 170 F. Supp. 613, 145 Ct. Cl. 298 (1959). Cf., Knetsch v. United States, 364 U.S. 361, 81 S. Ct. 132, 5 L. Ed. 2d 128 (1960); Deputy v. DuPont, 308 U.S. 488, 60 S. Ct. 363, 84 L. Ed. 416 (1940); Gregory v. Helvering, 293 U.S. 465, 55 S. Ct. 266, 79 L. Ed. 596 (1935).

This review presents another variant of the plans devised by M. Eli Livingstone, a Boston broker, several of which were the subject oof some of the foregoing decisions. They have generally been concerned with a plan for reducing income taxes through the device of claiming deductions for alleged payment of interest on loans to finance the purchase of Government securities.

Two plans are involved in the instant case. The Tax Court's findings of fact and opinion are not officially reported. This requires a summary statement of the facts in each situation.

The November, 1955 Transaction.

On November 22, 1955, Lewis directed Livingstone to purchase for his account $1,000,000 face value United States Treasury 2 7/8% notes due March 15, 1957, with interest coupons due March 15 and September 15, 1956, detached.

Livingstone confirmed the purchase at a price of 97 1/2, a total of $975,000. Livingstone also granted Lewis an irrevocable option, or "put," to sell the notes back to Livingstone on September 15, 1956 at a price of 100 3/4. There was no charge for the "put."

At the same time, Livingstone sent Lewis a note for $975,000 payable to Corporate Finance & Loan Corporation (CFL),*fn2 letters of instructions for Lewis' signature and Livingstone's check to Lewis for $32,500.This amount was paid to Lewis as security for the option granted him to sell the notes to Livingstone at the agreed price. Lewis retained the $32,500 and it was accounted for at the close of the transaction in 1956, when it was charged to his account. Livingstone acted as principal in the sale of the bonds and charged no commission.

Lewis was requested to sign the note and letters of instruction and return them to Livingstone, together with Lewis' check for $40,218.75 payable to CF&L. The check was purportedly a prepayment of interest. With the letter prepared for him by Livingstone, Lewis directed him to deliver the Treasury notes against payment of $975,000 to CF&L, and directed CF&L to pay this sum and receive the notes from Livingstone.

Lewis signed the note prepared by Livingstone. It was dated November 22, 1955, calling for the payment in one year of $975,000 to CF&L, with interest at 4 1/8% ($40,218.75) prepaid. It recited that Lewis had deposited the $1,000,000 Treasury 2 7/8% notes as collateral with CF&L. There was no provision for reimbursement of interest in event of prepayment of principal.

The transaction was recorded on the CF&L books with a debit entry of $975,000 to "Notes Receivable, Clients," and a credit entry in the same amount to "Loans Receivable, Livingstone & Co."

Livingstone placed a buy order with another dealer in Government securities, designated for Lewis' account, directing delivery of the $1,000,000 Treasury 2 7/8% notes due March 15, 1957, to a New York bank against payment. He instructed the bank to receive the securities against payment. He also placed another order directing a sale for the account of CF&L, and the receipt of the $1,000,000 2 7/8% notes from the bank against payment. He instructed the bank to deliver the securities to the dealer against payment. He paid the dealer the differential between the purchase and sale prices. The bank, which debited and credited Livingstone's account in the amounts of the sale and purchase prices, was paid a clearing fee for its services.

The Treasury notes never left the office of the dealer. Neither Lewis, Livingstone nor CF&L ever acquired actual physical possession of them. A confirmation slip sent by the dealer mentioned Lewis by name only, at Livingstone's request.

Lewis issued a check dated December 1, 1955 for $40,218.75, payable to CF&L. This was reflected as payment of ...

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