Kiley, Swygert and Cummings, Circuit Judges.
This lawsuit involves the proper construction of Section 265(2) of the Internal Revenue Code.*fn1 The question for resolution is whether the taxpayer may deduct from its gross income the interest it paid on its mortgage and some of its short-term loans.
Taxpayer is located in Sun Prairie, Wisconsin, and is in the business of packaging fancy cheeses for sale as Christmas gifts. Its business is seasonal and is most active during the last three months of each calendar year. Its sales are solicited exclusively through a catalog mailed each October. It incurs high costs in the last three months of each calendar year. Funds are borrowed annually from September through early November to cover such costs.
During the three fiscal years ending July 31, 1960, 1961 and 1962, taxpayer obtained short-term bank loans to meet its recurring needs for working capital. These borrowings took place each fall and were repaid, from late November through January, out of the receipts of each year's sales. The balance of the receipts was used to purchase municipal bonds and treasury bills. The treasury bills were acquired with staggered maturity dates to meet the off-season needs of the business. They were reduced to cash by the middle of each July. The municipal bonds were used as collateral for the bank loans, enabling taxpayer to borrow almost 100% of their value. On August 1, 1959, taxpayer had municipal bond holdings of $138,168.29. By July 31, 1962, these holdings had increased to $218,542.70.
In the second of the fiscal years involved, in order to build a new plant, taxpayer borrowed $69,360 from a bank. This loan was secured by a mortgage upon its real estate. The proceeds of the loan were used to pay for construction and not directly to purchase municipal bonds.
For these taxable fiscal years, the Commissioner of Internal Revenue disallowed taxpayer's deductions of interest on the mortgage and on some of the short-term loans.*fn2 The taxpayer paid the resulting assessments and later brought this refund suit against the United States.
The District Court held that taxpayer incurred the indebtedness to "carry obligations * * * the interest on which is wholly exempt" from Federal income tax within the meaning of Section 265(2) of the Internal Revenue Code. Therefore, judgment was entered for the United States. We agree as to the interest on the short-term loans but not as to the mortgage interest.
Interest on Short-Term Loans
During each fall in the years in question, taxpayer used its municipal bonds as collateral for short-term bank loans for essential working capital. Instead of resorting to bank loans, taxpayer could have sold its municipals to meet the high cost seasonal needs of its business. Because this alternative was available to taxpayer, the Government argues that the short-term indebtedness was automatically incurred in order to enable taxpayer to "carry [tax-exempt] obligations," so that the interest on this indebtedness would be non-deductible under Section 265(2) of the Internal Revenue Code, supra, note 1. The District Court construed Section 265(2) as forbidding the deduction of interest on indebtedness incurred or continued "in order to" or "for the purpose of" carrying tax-exempt obligations. We approve this construction but do not believe deduction is forbidden whenever taxpayer has an alternative of liquidating tax-exempts in lieu of borrowing.
The taxpayer contends that the short-term loans were incurred for the purpose of meeting its heavy fall seasonal financing needs, whereas the Government contends that the indebtedness was incurred for the purpose of making it possible for taxpayer to carry its municipal securities. In holding that the interest on the short-term loans could not be deducted, the District Court stated:
"To accomplish the purpose of obtaining cash to meet plaintiff's seasonal needs, it was not a condition precedent that indebtedness be incurred. To accomplish the purpose of carrying the municipal securities, it was a condition precedent that indebtedness be incurred."
In reaching its conclusion that no refund was due, the District Court construed the Congressional intent as not to grant a deduction for interest payments by a taxpayer who holds securities, the interest from which is not taxable. This is the double benefit prohibited by Section 265(2). Stated another way, Congress sought to prevent a taxpayer from requiring the United States to finance its investments. United States v. Atlas Life Insurance Co., 381 U.S. 233, 247, 85 S. Ct. 1379, 14 L. Ed. 2d 358.
In our view, the taxpayer is not ipso facto deprived of a deduction for interest on indebtedness while holding tax-exempt securities. The Government has not convinced us that interest deduction can be allowed only where the taxpayer shows that he wanted to sell the tax-exempt securities but could not. For example, Congress certainly did not intend to deny deductibility to a taxpayer who holds salable municipals and takes out a mortgage to buy a home instead of selling the municipals. As the ...