Gold v. Commissioner ( 1963 )

J. George Gold and Jennie R. Gold, Petitioners, v. Commissioner of Internal Revenue, Respondent

Gold v. Commissioner

Docket No. 80082

United States Tax Court

41 T.C. 419; 1963 U.S. Tax Ct. LEXIS 1;

December 31, 1963, Filed

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Decision will be entered for the respondent.

Held, alleged short sale of $ 2 million United States notes was a sham, and interest in respect of such notes purportedly paid by the alleged seller during the period of the "short sale" was not deductible as an expense paid "for the production or collection of income." Sec. 212(1), I.R.C. 1954. Alternatively, the "short sale" was a component part of a transaction purportedly involving the purchase of tax-exempt New York Housing Authority notes, and if these transactions were not shams, the acquisition of the Housing Authority notes must be regarded as having been financed by the short sale, with the consequence that the claimed deduction is forbidden by section 265.

J. George Gold, pro se.

Roger Rhodes and John Schessler, for the respondent.

Raum, Judge.

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RAUM

The Commissioner determined a deficiency in petitioners' 1956 income tax in the amount of $ 4,620.15. At issue is whether interest due on U.S. Government obligations allegedly sold short to the Gibraltar Financial Corporation was in fact paid in 1956 to that corporation and was deductible by petitioners as an expense paid in 1956 for the production or collection of income.

FINDINGS OF FACT

The facts stipulated by the parties and exhibits introduced in evidence are incorporated herein by this reference.

The petitioners, husband and wife residing in Los Angeles, Calif., filed their joint Federal income tax return for 1956, on the cash basis, with the district director of internal revenue in Los Angeles. The husband will hereinafter be referred to as petitioner.

Petitioner is an attorney engaged in the practice of law in Beverly Hills, Calif. His income from his law partnership in 1956 was $ 27,426.68, and the total adjusted gross income reported on his 1956 joint return (after a $ 1,000 capital loss carryover) was $ 26,426.68. On that return a deduction was claimed in the amount of $ 20,390.59 as an expense of carrying U.S. Government obligations allegedly sold short by him to the Gibraltar Financial Corporation, hereinafter referred to as Gibraltar, and allegedly paid to that corporation. It is the Commissioner's disallowance of that deduction, claimed by petitioners under section 212(1), I.R.C. 1954, "as ordinary and necessary expenses paid * * * (1) for the production or collection of income," which is at issue in these proceedings.

Gibraltar, a dealer in securities, was incorporated on or about December 24, 1952. Its initial working capital as of December 29, 1952, consisted of $ 3,500, of which $ 1,500 was borrowed and $ 2,000 was contributed by its shareholders. The balance sheets of Gibraltar as of December 1, 1954, December 1, 1955, and December 1, 1956, reflected the following:

		Dec. 1, 1954	Dec. 1, 1955	Dec. 1, 1956
Assets:
	Cash in banks	$ 41,811.89	$ 53,158.47	$ 24,401.12
	Notes and accounts
	receivable	71,429,584.38	67,138,865.35	69,599,555.29
	Brokers receivable	27,960,654.41
	Securities owned -- long	39,076.14	24,265,377.39	22,614,932.66
	Other assets	4,067.60	690.11	7,570.88
	Total	99,475,194.42	91,458,091.32	92,246,459.95
Liabilities:
	Brokers payable		282,738.37	25.97
	Accounts payable	814.62		932.10
	Loans payable -- bank
	(secured)	43,000.00	1,716,000.00	109,000.00
	Securities borrowed	99,687,201.12	89,541,234.04	92,214,677.17
	Accrued expenses	9,958.11	18,296.29	17,824.58
	Capital stock	2,000.00	2,000.00	2,000.00
	Deficit	(267,779.43)	(102,177.38)	(100,999.87)
	Total	99,475,194.42	91,458,091.32	92,246,459.95

Cantor, Fitzgerald & Co., Inc., hereinafter referred to as Cantor, Fitzgerald, is a broker and dealer in securities located in Beverly Hills, Calif.

Petitioner's 1956 joint return reported no income from any source apart from his law practice. He owned no securities of any kind and received no interest from bank accounts or any other source; nor did he receive any rents or other type of income from real estate or any other kind of property. He had previously made but very few purchases of securities, and the largest amount that he had ever invested in securities was approximately $ 10,000; he was not generally familiar with prices of Treasury notes, and had very little, if any, experience in trading in Treasury bonds or notes.

Pursuant to suggestions of a man named Miller, a salesman for Cantor, Fitzgerald, petitioner purported to enter into certain transactions on October 5, 1955, whereby he allegedly made a short sale of $ 2 million U.S. Treasury 2-percent notes due August 15, 1956, to Gibraltar and at the same time purported to deposit with Gibraltar as security $ 2 million New York City Housing Authority 1.58-percent notes dated October 10, 1955, and due April 9, 1956.

The "short sale" was purportedly based upon an agreement dated October 5, 1955, between petitioner and Gibraltar. The agreement was embodied in a printed form prepared for Gibraltar, entitled "Customer's Short-Sale Agreement"; petitioner was identified therein as "the Customer." The agreement provided in part as follows:

Whereas, the Customer is desirous of selling certain securities to Gibraltar, and

Whereas, Gibraltar is desirous of purchasing certain securities,

Now, Therefore, it is mutually agreed as follows:

(1) Gibraltar shall purchase from the Customer and the Customer shall sell to Gibraltar, the following securities: $ 2,000,000 U.S. Treasury 2% notes due August 15, 1956.

(2) The Customer shall make delivery of the above described securities on or before the maturity date of said securities.

(3) The Customer hereby deposits with Gibraltar the sum of $ 5,000.00 as collateral security, subject to the terms of this agreement.

(4) Gibraltar shall credit the account of the Customer with the purchase price of the above described securities and pay such proceeds to the Customer upon the happening of any one of the following:

[a] the delivery to Gibraltar by the Customer of said securities, or

[b] the depositing by the Customer of other United States Government, State or Municipal securities in kind and amount acceptable and approved by Gibraltar, as collateral security pending the delivery of the above described securities, and the execution by the parties of a pledge agreement in form and manner prescribed by Gibraltar.

(5) The Customer agrees to pay to Gibraltar all sums which shall accrue to Gibraltar as the legal owner of the above described securities until such time as the above described securities are delivered to Gibraltar. Such payments are to be made at such times as Gibraltar would have been entitled to such proceeds if it had the actual possession of said securities.

No sales price appears anywhere in the "short sale" agreement; however, a "confirmation" slip from Gibraltar to petitioner, dated October 4, 1955, purported to confirm a purchase "today" by Gibraltar from petitioner of U.S. Treasury notes in the principal amount of $ 2 million at par plus $ 15,488.23 interest. Gibraltar credited petitioner's account in the amount of $ 2,015,488.23 as payment for the Treasury notes; the entry date for the credit was October 3, 1955.

On October 7, 1955, petitioner in fact issued his $ 5,000 check to Gibraltar pursuant to paragraph (3) of the foregoing agreement.

On October 5, 1955, petitioner also entered into a "Short-Sale Pledge Agreement" whereby he agreed, pursuant to (4) [b] of the "Customer's Short-Sale Agreement," to deposit with Gibraltar "$ 2,000,000 New York City Housing Authority 1.58% notes dated October 10, 1955, due April 9, 1956," hereinafter referred to as the Housing Authority notes, as security pending his delivery of the Treasury notes he purportedly sold short. This agreement further provided:

The said securities shall be deposited with and held by Gibraltar to secure the delivery of the securities heretofore sold to Gibraltar by the Customer as set forth in the "Customer's Short-Sale Agreement", and for the payment of any other sums which may accrue by virtue of any claim whatsoever arising out of this transaction, subject to the terms of this agreement. Upon the receipt by Gibraltar of the above securities, it shall pay over to the Customer the sum of $ 2,000,000.00 out of the sum of $ 2,015,488.23 heretofore credited to the Customer's account pursuant to the terms of the "Customer's Short-Sale Agreement" in connection with the sale of the securities heretofore purchased by Gibraltar.

(2) The Customer agrees that until delivery is made of the securities set forth in the "Customer's Short-Sale Agreement", GIBRALTAR shall hold the securities deposited hereunder and may from time to time and without prior notice to the Customer, pledge and repledge, borrow, hypothecate and rehypothecate either separately or with other securities for any amount due upon the Customer's account or accounts or for any greater amount, and interest, or may be loaned, sold, transferred or disposed of by GIBRALTAR in any manner whatsoever that GIBRALTAR may see fit without GIBRALTAR retaining in its possession or control for delivery a like amount of similar securities deposited hereunder. GIBRALTAR shall have the right to use the securities deposited hereunder to cover the delivery of the same or similar securities which it may sell as principal to others. It is understood that GIBRALTAR shall not be required to deliver to the Customer the same certificates or securities deposited or received hereunder, but only certificates or securities of the equivalent denominations and face value. If there is a default on the part of the Customer in the delivery to GIBRALTAR of the securities previously sold, GIBRALTAR may, without prior notice to the Customer, purchase from the Customer or sell to others at any time within its judgment and discretion (including but not limited to the date of the delivery of the securities previously sold for which the securities hereunder are deposited as collateral), the securities so deposited hereunder at the market value and credit to the Customer's account the amount representing the value of the securities deposited hereunder. Market value, as used herein, shall mean the closing bid price of the day. If there is a deficiency after such sale, the Customer shall remain liable therefor and his account charged accordingly. Upon delivery to GIBRALTAR of the securities previously purchased, as set forth in the "Customer's Short-Sale Agreement", it shall have the right to deliver to the Customer a like amount of similar securities deposited hereunder or, at its option, it may purchase said securities from the Customer at their market value and credit the Customer's account with the market value of the said securities.

* * * *

(4) All interest earned on the securities deposited hereunder shall be credited to the account of the Customer during the continuance of this agreement on such dates as the interest becomes due and would have been received by the Customer had he not pledged the securities hereunder, and GIBRALTAR shall, upon receiving the same, pay such sums to the Customer.

The $ 2 million Housing Authority notes had purportedly been purchased for petitioner by Cantor, Fitzgerald, pursuant to instructions given by him on October 4, 1955. A "Confirmation and Statement" of Cantor, Fitzgerald, dated October 4, 1955, and bearing a settlement date of October 10, 1955, purported to confirm to C. J. Devine and Co., of New York, N.Y., that it had purchased, as broker, from that company the $ 2 million Housing Authority notes with instructions to C. J. Devine & Co. to deliver the notes to the Chemical Corn Exchange Bank, hereinafter referred to as the Chemical Bank, against payment of $ 2 million, the price being 100 (par). The Chemical Bank was a "clearing and disbursing" agent for Cantor, Fitzgerald, in the transactions material to this proceeding. A "Confirmation and Statement," also dated October 4, 1955, and bearing a settlement date of October 10, 1955, purported to confirm that Cantor, Fitzgerald had purchased, as broker, for petitioner's account, the Housing Authority notes; the Chemical Bank was instructed to deliver the notes to the Irving Trust Co. "acct. The Gibraltar Financial Corporation, for the account of" petitioner against payment of $ 2 million. The Irving Trust Co. was the "clearing and disbursing" agent for Gibraltar in the transactions material to this proceeding.

An "Advice" dated October 10, 1955, reflected that the Chemical Bank had charged Cantor, Fitzgerald's account in the amount of $ 2 million in respect of its purchase of the Housing Authority notes from C. J. Devine and Co.

A confirmation slip dated October 10, 1955, from the Irving Trust Co. to Gibraltar purports to show that it had received for Gibraltar from --

"Chemical Corn Exchange Bank

A/C Cantor, Fitzgerald & Co., Inc., A/C

J. George Gold"

Housing Authority notes in the principal amount of $ 2 million, bearing the numbers 76/90 at $ 100,000 and 91/100 at $ 50,000; and that it charged Gibraltar's account in the amount of $ 2,000,200, of which $ 2 million was principal and $ 200 designated as "our charge." The confirmation slip contained the words "Redeliver vs. Payment," and the "charge" was explained as follows: "our chge. covers recpt. & del. of bds."

Another confirmation slip, also dated October 10, 1955, from the Irving Trust Co. to Gibraltar, shows that Irving Trust Co. had delivered, for Gibraltar's account, to Joseph Faroll & Co., $ 2 million Housing Authority notes having the same numbers as those referred to in the preceding paragraph. The notes had purportedly been sold by Gibraltar to Joseph Faroll & Co., a broker and dealer in securities, at 99 63/64, and the confirmation slip from Irving Trust Co. to Gibraltar shows that it had credited Gibraltar's account in the amount of $ 1,999,487.50. ^{*13 of $ 2,000,000."}

At no time did either Gibraltar or petitioner acquire possession of the Housing Authority notes. The record does not show that there was any moment in time when petitioner had control over the Housing Authority notes he purportedly purchased through Cantor, Fitzgerald and deposited as security for the purported short sale of the Treasury notes; the notes never left the Irving Trust Co. and Gibraltar made payment to that bank for the Housing Authority notes by using the proceeds from the sale of the identical Housing Authority notes to Joseph Faroll & Co. The only exchange of funds in connection with this alleged purchase by petitioner was the net charge to Gibraltar's account with the Irving Trust Co. in the amount of $ 512.50, the difference between the purchase price purportedly paid to Cantor, Fitzgerald plus "charge" by the Irving Trust Co., and the selling price to Joseph Faroll & Co. The purchase was consummated only by virtue of the matching sale of the identical Housing Authority notes. The net effect of this transaction was a wash. Neither petitioner nor Gibraltar had the necessary funds with which to make such a purchase.

As of October 10, 1955, Gibraltar's books reflected a credit balance in petitioner's favor in the amount of $ 20,488.23, arrived at as follows: A credit of $ 2,015,488.23 as the proceeds of the alleged short sale of the Treasury notes minus a $ 2 million debit in respect of the Housing Authority notes, plus a $ 5,000 credit in respect of petitioner's cash deposit.

On February 16, 1956, petitioner's account with Gibraltar was debited in the amount of $ 29,944.75. This debit represented the February 15, 1956, interest coupons on the Treasury notes allegedly sold short.

A "Confirmation" of Gibraltar to petitioner dated April 4, 1956, reflected a "purchase" from petitioner of the Housing Authority notes for $ 2,015,712.22, of which $ 2 million was the principal and the remainder interest; the purchase price was at par (100). This "purchase" was made solely by a bookkeeping entry; Gibraltar credited petitioner's account in the amount of $ 2,015,712.22. The record does not show that at the time of this purported purchase, any such Housing Authority notes were in the possession or control of either petitioner or Gibraltar, or that either of them had any interest whatever in any such notes, or that there was even a simultaneous purchase and sale through a broker.

A "Confirmation" of Gibraltar to petitioner dated April 6, 1956, reflected a "sale" to petitioner of the Treasury notes at 99.31; the total selling price was $ 2,005,309.07, of which $ 1,999,375 was designated as principal and the remainder interest. This "sale" was merely a bookkeeping entry; it was accomplished solely by a charge to petitioner's account in the amount of $ 2,005,309.07. The record does not show that there were any such Treasury notes in the possession or control of either petitioner or Gibraltar, or that either of them had any interest whatever in any such notes, or that there was even a simultaneous purchase and sale through a broker. Petitioner's account with Gibraltar, as of April 9, 1946, reflected a credit balance in the amount of $ 946.63; this amount was remitted to petitioner on April 12, 1956, by check and petitioner's account at that time reflected a zero balance.

A schedule of capital gains and losses appended to petitioners' income tax return for the year 1956 reflected the following:

					Gain or loss
	Date	Date			on sale or
Kind of property	acquired	sold	Sales price	Cost	exchange --
					long-term
					gain
$ 2,000,000 U.S.
Treasury notes	4/9/56	10/5/55	$ 2,000,625	$ 2,000,000	$ 625.00
$ 2,000,000 New
York Housing
Authority notes	10/5/55	4/9/56	2,000,000	2,000,000

The only outlay of money made by petitioner was $ 5,000, the amount given to Gibraltar in 1955 which allegedly represented "collateral security" for the purported short sale. Of that amount, $ 946.63 was returned to petitioner on April 12, 1956. The only expenditure made by Gibraltar in connection with the aforementioned transactions was the $ 512.50 referred to above.

The aforementioned "short sale" of Treasury notes and the "purchase" of Housing Authority notes were arranged at approximately the same time by Miller, or by someone else connected with Cantor, Fitzgerald; they were interrelated component parts of a sham. Petitioner in fact made no short sale of Treasury notes to Gibraltar, nor did he in fact purchase Housing Authority notes and deposit them with Gibraltar as security.

The amount in controversy, $ 20,390.59, claimed as a deduction in 1956, purportedly reflected in petitioner's account on Gibraltar's books, was not in fact paid by petitioner in 1956 or at any other time; nor if paid, was it an ordinary and necessary expense paid for the production or collection of income.

OPINION

Petitioner's 1956 return claimed a deduction of $ 20,390.59 as an "expense in respect of carrying" the $ 2 million Treasury notes which he had allegedly sold short to Gibraltar. He attempts to support the deduction under section 212(1) of the 1954 Code as an "ordinary and necessary expense paid or incurred during [1956] * * * for the production or collection of income." How that $ 20,390.59 figure was computed is nowhere explained in the record, but it appears to be equal to the interest accruing on the $ 2 million Treasury notes during the period of the so-called short sale *18 It is, of course, true that one who borrows securities in order to make a short sale may deduct the amount of interest or dividends which he pays to the lender in order to reimburse him for the interest or dividends that the lender would have received during the period of the loan. Commissioner v. Wiesler, 161 F. 2d 997 (C.A. 6); Carl Shapiro, 40 T.C. 34">40 T.C. 34, 38; I.T. 3989, 1 C.B. 34">1950-1 C.B. 34. However, that rule is inapplicable here because petitioner has failed to show that there was in fact any bona fide short sale of $ 2 million Treasury notes or that he in fact paid the amount in question in respect of the notes allegedly sold short.

The record fails to show that any such Treasury notes were ever borrowed by or on behalf of petitioner for delivery to Gibraltar; or that, even considering his agreement with Gibraltar as an undertaking to deliver the notes at a future time, he ever made any such delivery or ever in fact intended to make any such delivery; or that the closing of the transaction in April 1956 by bookkeeping entries pretending to reflect a "resale" of the notes to petitioner wasn't part of a preconceived plan that contemplated no actual dealings in Treasury notes. Carl Shapiro, 40 T.C. 34">40 T.C. 34, 39.

We cannot find on this record that there ever was any bona fide short sale between petitioner and Gibraltar. Nor is his position strengthened by the evidence relating to the $ 2 million Housing Authority notes which he purportedly purchased and put up as collateral for his alleged obligations under the "short sale" agreement. Although it is true that, unlike the nonexistent Treasury notes, there were specifically identifiable Housing Authority notes, it does not appear that petitioner ever acquired any ownership of or control over such notes for a period of even a split second. The various documents in evidence give merely a misleading appearance of the purchase of the notes by petitioner. When the smoke cleared away, these notes found themselves in the hands of an unrelated third party, namely, Joseph Faroll & Co., a broker who appears to have been the true purchaser of those Housing Authority notes. There is no evidence whatever that after October 10, 1955, the so-called closing date for the transactions allegedly initiated on October 5, 1955, there were any Housing Authority notes or Treasury notes in the possession or control of either petitioner or Gibraltar. Nor is there any convincing evidence that any of the parties ever intended in fact to obtain any such notes with which to consummate the transactions which had theoretically been commenced. The various bookkeeping entries made thereafter on Gibraltar's books, which furnish the basis for petitioner's claimed $ 20,390.59 deduction, have all the earmarks of what is sometimes referred to as a bucket shop operation.

In view of the record before us, we have found that the "short sale" of the Treasury notes and "purchase" of the Housing Authority notes were interrelated component parts of a sham; that petitioner in fact made no short sale; and that he did not in fact pay the $ 20,390.59 purportedly reflected in his account on Gibraltar's books. The amount in question represents phantom interest on phantom notes in a phantom short sale. The disallowance of the claimed deduction is in accord with an ever lengthening line of decisions reaching like results in a variety of situations comparable to the one before us. Carl Shapiro, 40 T.C. 34">40 T.C. 34; Eli D. Goodstein, 30 T.C. 1178">30 T.C. 1178, affirmed 267 F. 2d 127 (C.A. 1); Broome v. United States, 170 F. Supp. 613">170 F. Supp. 613 (Ct. Cl.); Sonnabend v. Commissioner, 267 F. 2d 319 (C.A. 1), affirming per curiam a Memorandum Opinion of this Court; Lynch v. Commissioner, 273 F. 2d 867 (C.A. 2), affirming 31 T.C. 990">31 T.C. 990 and Leslie Julian, 31 T.C. 998">31 T.C. 998; Egbert J. Miles, 31 T.C. 1001">31 T.C. 1001; Becker v. Commissioner, 277 F. 2d 146 (C.A. 2), affirming a Memorandum Opinion of this Court; Morris R. DeWoskin, 35 T.C. 356">35 T.C. 356, appeal dismissed (C.A. 7); Perry A. Nichols, 37 T.C. 772">37 T.C. 772, affirmed 314 F. 2d 337 (C.A. 5); Empire Press, Inc., 35 T.C. 136">35 T.C. 136. Cf. Knetsch v. United States, 364 U.S. 361">364 U.S. 361; ^{Amor F. Pierce, 37 T.C. 1039">37 T.C. 1039, affirmed 311 F. 2d 894 (C.A. 9); A. A. Helwig, 37 T.C. 1046">37 T.C. 1046; United States v. Roderick, 290 F. 2d 823 (C.A. 5); Bridges v. Commissioner, 325 F. 2d 180 (C.A. 4), affirming 39 T.C. 1064">39 T.C. 1064; MacRae v. Commissioner, 294 F. 2d 56 (C.A. 9), affirming in part and remanding in part 34 T.C. 20">34 T.C. 20, certiorari denied 368 U.S. 955">368 U.S. 955; Kaye v. Commissioner, 287 F. 2d 40 (C.A. 9), affirming per curiam 33 T.C. 511">33 T.C. 511; Weller v. Commissioner, 270 F. 2d 294 (C.A. 3), affirming 31 T.C. 33">31 T.C. 33 and W. Stuart Emmons, 31 T.C. 26">31 T.C. 26, certiorari denied 364 U.S. 908">364 U.S. 908; William R. Lovett, 37 T.C. 317">37 T.C. 317.}

We may add that even if the $ 20,390.59 had been paid, it would not qualify for deduction, since in our view it was not related to the "production or collection" of income under section 212(1). We do not believe petitioner's testimony that he had any purpose in entering into these transactions other than to obtain a tax deduction, and, as we said in Carl Shapiro, supra at 39-40, "the avoidance of taxes hardly qualifies as 'the production or collection of income' under the statute, either literally or by any implication that is supported by any relevant legislative history." Moreover, even if the transactions herein were to be treated as bona fide, the claimed deduction would have to be disallowed in any event under section 265. *25 On the hypothesis that the transactions were bona fide the purchase of the tax-exempt Housing Authority notes would have to be regarded as having been financed by the proceeds of the short sale, with the result that the expenses incurred in connection with the short sale would have to be treated as allocable to tax-exempt income under section 265 and therefore nondeductible. Bernard H. Jacobson, 28 T.C. 579">28 T.C. 579; Constance M. Bishop, 41 T.C. 154">41 T.C. 154.

Decision will be entered for the respondent.

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Footnotes

• 1. The purchase price at 99 63/64 would be $ 1,999,687.50. The $ 200 difference apparently reflects the Irving Trust Co.'s "charge," referred to in the other confirmation slip.↩

• 2. That amount appears to consist of two components: (a) $ 14,456.52, which represents the amount of the February 15, 1956, interest coupons of $ 29,944.75 minus the $ 15,488.23 interest which had already accrued in respect of those coupons by October 5, 1955, the time of the alleged short sale; and (b) $ 5,934.07 interest accruing on the bonds from the date of the foregoing interest coupons, February 15, 1956, to the date of the alleged resale of the bonds by Gibraltar to petitioner in April 1956.↩

• 3. See 2 Loss, Securities Regulation 1226 (2d ed. 1961):

  Today the courts' touchstone in distinguishing between gambling contracts on the one hand and short sales of securities (or commodity futures contracts or contracts to sell securities "when issued") on the other hand is whether there was an intent to deliver when the contract was made rather than merely to adjust price differences later.↩

• 4. Indeed, while the Knetsch case was pending in the Supreme Court the parties herein filed a joint motion for continuance of the present case on the ground that the then undecided Knetsch↩ case "involves the same issues as are presented in the [instant] * * * case, and the parties believe that the decision by the Supreme Court will provide a basis for disposing of the [instant] * * * case without litigation."

• 5. SEC. 265. EXPENSES AND INTEREST RELATING TO TAX-EXEMPT INCOME.

  No deduction shall be allowed for --

  (1) Expenses. -- Any amount otherwise allowable as a deduction which is allocable to one or more classes of income other than interest (whether or not any amount of income of that class or classes is received or accrued) wholly exempt from the taxes imposed by this subtitle, or any amount otherwise allowable under section 212 (relating to expenses for production of income) which is allocable to interest (whether or not any amount of such interest is received or accrued) wholly exempt from the taxes imposed by this subtitle.

  (2) Interest. -- Interest on indebtedness incurred or continued to purchase or carry obligations (other than obligations of the United States issued after September 24, 1917, and originally subscribed for by the taxpayer) the interest on which is wholly exempt from the taxes imposed by this subtitle.↩

• 6. The tax-exempt interest on the Housing Authority notes was an essential ingredient of the tax-avoidance device before us, for it was through the application of such alleged nontaxable receipts against the interest purportedly owed to Gibraltar on the Treasury notes that Gibraltar was able to create the illusion on its books that petitioner had "paid" the major part of the interest in respect of the Treasury notes. In fact, however, petitioner had no receipts of any kind, tax exempt or otherwise, from any Housing Authority notes and paid no interest in respect of the Treasury notes.↩