Mississippi Chemical Corporation v. United States of America, Coastal Chemical Corporation v. United States

GEWIN, Circuit Judge:

The government appeals from separate judgments entered for Mississippi Chemical Corporation and Coastal Chemical Corporation (hereinafter, taxpayers) in their suits for refund of federal taxes. Taxpayers based their claims for refund on the contention that $99 of each $100 expended for the purchase of certain Class C stock in the New Orleans Bank for Cooperatives constituted deductible expenses in the year of purchase. The government contended that these amounts were the nondeduetible costs of acquiring capital assets. The district court concluded that the payments were deductible as interest expenses, and we affirm.

Taxpayers are Mississippi corporations with their principal place of business in Yazoo City, Mississippi. During the tax years in question they were “cooperative associations” as defined in the Agricultural Marketing Act.¹ Taxpayers are stockholders in, and borrowers from, the New Orleans Bank for Cooperatives (hereinafter, the Bank). The Bank is part of a banking system created by the federal government² during the depression to provide low cost loans to farmer’s marketing, purchasing, and service cooperatives. It is one of the twelve regional banks in the system and serves Louisiana, Mississippi, and Alabama.

The governing legislation³ provides for three classes of stock in a regional bank. Class A stock represents the original capital contributed by the United States. These shares are non-voting and pay no dividend. The legislation contains a scheme of retirement for Class A shares which is dependent on the amount of Class C stock purchased and on the net profits of the regional bank. Class B stock may be issued to any person. It is non-voting but may bear a dividend not to exceed four percent per annum. Class C stock may only be issued to banks for cooperatives and to farmers’ cooperative associations. It pays no dividend. Each holder of Class C stock is entitled to one vote, though a cooperative has only the single vote regardless of the number of Class C shares held.

Farmers cooperatives, like taxpayers, acquire Class C shares in three ways: (1) Each cooperative must purchase a qualifying share of Class C stock to be eligible to borrow from the Bank. (2) A borrower cooperative is required to make quarterly investments in Class C stock; these purchases are referred to as “interest override” payments. The amount required to be invested is not less than ten nor more than twenty-five percent of the interest payable by the borrower for that quarter, to be determined by the Bank’s directors.⁴ (3) Class C stock is also received by farmers’ cooperatives as a distribution of the Bank’s net profits during a fiscal year. These distributions, called “patronage refunds”, are computed in amount “in the proportion that 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 fiscal year.”⁵

Mississippi Chemical Corporation acquired its qualifying share of Class C stock in 1956; Coastal Chemical Corporation purchased its share in 1957. Each carried its initial share on its books at the $100 cost, and neither sought a deduction for any part of this expense. These qualifying shares were not involved in the suit below.

Mississippi Chemical’s suit concerned the fiscal years ending 30 June 1961, 1962, and 1963. As a result of its borrowings during those years it was required to make “interest override” purchases of 189, 169, and 193 shares of Class C stock respectively. The purchase price of each share of stock was $100. In its tax returns for each year, Mississippi Chemical reported $1 per share as the cost of acquiring a capital asset and claimed a deduction in the amount of $99 a share as an interest expense. In the same fiscal years, Mississippi Chemical received “patronage refunds” of 287, 275, and 251 shares of Class C stock respectively. It reported $1 per share of the “patronage refund” as a reduction of interest expense and investments, but it made no report of the remaining $99 of par value of each share.

Coastal Chemical’s suit involved a longer period of time including the fiscal years ending 30 June 1958 through 1963. In these years Coastal Chemical purchased 118, 339, 473, 417, 351, and 421 shares of Class C stock respectively pursuant to the “interest override” requirements. During the same years, it received 143, 474, 516, 605, 523, and 630 shares of Class C stock as “patronage refunds.” In its tax returns for these periods, Coastal Chemical treated the shares purchased and those received as “patronage dividends” in the same manner as Mississippi Chemical.

The Commissioner disallowed the interest deduction claimed by each taxpayer and asserted deficiencies. Taxpayers paid the deficiencies and filed claims for refund which were disallowed. Taxpayers then instituted their actions which were consolidated for trial in the district court. The court below upheld the taxpayer’s contention that $99 of each $100 expended for the purchase of a share of Class C stock was deductible as an interest expense. In the district court the government also contended that taxpayers should have reported the Class C stock received as patronage refunds as income. The court did not sustain this position and it has been abandoned by the government.⁶ As a result the present appeal is concerned solely with the tax treatment of the Class C stock purchased under the “interest override” requirements of 12 U.S.C. § 1134d(a) (3).⁷

I

Central to the district court’s decision was its finding that the Class C stock,⁸ while not worthless, was without any appreciable market value and had at most a nominal value. This conclusion is attributable to the peculiar nature of these shares. Taxpayers could only sell or transfer Class C stock to another qualified farmers’ cooperative with the authorization of the Bank’s Board of Directors and the approval of the Farm Credit Administration. No share of the Bank’s Class C stock has ever been sold by a cooperative,⁹ so there is obviously no market in this stock that would aid evaluation.

Additional characteristics of the stock severely limit its value in the hands of the taxpayers. It pays no dividend and has no growth potential. After the purchase of their initial, qualifying shares, taxpayers gained no voting rights by the purchase of additional Class C stock. The Bank has a first lien on all Class C shares.¹⁰ While the governing legislation provides that Class C shares may be retired at some date in the future, retirement will be at par ($100) and must await the prior retirement of all Class A stock and all senior Class B shares. Retirement is also subject to the discretion of officials of the bank system. Until this uncertain retirement date,¹¹ the shares have no value to taxpayers in the usual sense. The Bank will not accept Class C shares in satisfaction of future “interest override” obligations, nor will it accept Class C shares as collateral for a loan. These factors, the limited marketability and limited value of the shares themselves, make application of the normal “willing buyer and willing seller” standard, for determining fair market value,¹² unfeasible.

The government appears to concede that these shares have no market value,¹³ but urges that they possess an “intrinsic” or “intangible” value in taxpayers’ hands which renders their cost a capital investment. First, it contends that taxpayers benefit from low cost loans and other Bank services because of the existence of the banking system assured through their continued purchases of Class C stock. As has been noted, however, the right to Bank services is established by the purchase of the initial qualifying shares. The government also points to the history of the Banks for Cooperatives¹⁴ which evidences a Congressional intention ultimately to withdraw all government investment from the system. This is to be accomplished by the retirement of Class A stock as the federal investment it represents is replaced by Class C investment through purchases by cooperatives and receipt by them of “patronage refunds.” The government urges that when all Class A stock has been retired, the revolving fund method of capitalization, common to cooperative financing, will prevail and the participating cooperatives will be the sole owners of a valuable financial institution. It should be noted that ownership here is not synonymous with control:

Prior to 1964, the holders of class C stock of each [regional] bank could elect only one of its seven directors, and since 1964, they have elected two of the seven. The other five directors are elected by the local district Production Credit Associations (two members), and the local district Federal Land Bank Associations (two members), with the seventh being appointed by the Governor of the Farm Credit Administration.¹⁵

With their share of control in the Bank thus limited, the fact that Class C shareholders were having capital they supplied substituted for that previously furnished by the government can scarcely be seen as enhancing the value of their shares. In Penn Yan Agway Cooperative, Inc. v. United States,¹⁶ the Court of Claims rejected the same government argument —that the Class C shares possessed intangible value. The court stated:

[T]he cold fact remains that when plaintiff cooperative shareholder paid the $407 for the 4.07 shares, it received stock which was greatly less valuable from an economic and financial standpoint than the purchase price required by law and the terms of the loan agreements. The “intangible benefits” bestowed by Congress on farmers’ cooperatives generally do not alter this fact. * * * The required purchase of such stock gave plaintiff no economic or financial benefit other than the circumstance that it could not have obtained the loan with its favorable interest rate without fulfillment of the statutory requirement. But in the extremely practical field of taxation, in which substance prevails over form, it cannot reasonably be concluded under the circumstances that Congress has granted favors to cooperatives in furtherance of agricultural policies and taken them away (on the theory of intangible benefits) in whole or part in the field of raising of public revenues. It is obvious under the facts of this case that plaintiff did not consider, nor could it reasonably be held to have considered, that its required payment of $407 for such stock, was an investment, as no return on such purported investment could be realized, except repayment of the bare purchase price delayed for many years.¹⁷

In Penn Yan, the cooperative shareholder assigned a value of $6.90 to its Class C shares and introduced expert testimony tending to support this general figure as a reasonable estimate of the shares’ fair market value. The Court of Claims approved the cooperative’s evaluation. In M.F.A. Central Cooperative v. Book-waiter,¹⁸ the district court concluded that Class C shares in the St. Louis Bank for Cooperatives had no fair market value at all. This conclusion was reversed by the Eighth Circuit which stated, “While the Class C stock has no established market value, it has a substantial book value and while it is likely not worth its par value at the time it is issued, it certainly has substantial value.”¹⁹ It should be noted that there is a considerable difference, as to the factors affecting value, between the shares of the St. Louis bank and those involved here.²⁰ In the present case, considering the nature of the Class C stock and the testimony as to its value adduced in the district court, that court was not clearly erroneous in determining that the Class C shares had no fair market value and no more than a nominal value to the taxpayers.²¹

II

Notwithstanding the absence of a fair market value for the Class C shares, the government contends that taxpayers were not entitled to deduct any portion of their purchase price. It cites Montana Power Co. v. United States²² contending :

If one buys something and pays more than it is worth, and more than he can resell it for, there are no immediate tax consequences of this everyday occurrence. * * * He must “realize” his bad bargain, his loss, by selling.

We do not dispute the soundness of this tax principle, but consider it inapplicable to the present case.²³ The government advanced the same argument in the Penn Yan case. The Court of Claims rejected it stating:

[I]t would be unfair and unjust to apply such a doctrine in the circumstances where disposition by the plaintiff of the class C stock was a practical impossibility due to lack of a market, which resulted from the statutory restrictions placed upon such stock under the capitalization formula prescribed by law for the banks for cooperatives.²⁴

Montana Power and the other cases relied on by the government are readily distinguished from the present situation. Taxpayers in the instant case have not been the victims of a bad bargain in the traditional sense;²⁵ they were required to make continued purchases of Class C stock in order to secure loans from the Bank. Neither did taxpayers acquire an asset of continuing value, though less than the purchase price;²⁶ the Class C shares were of no appreciable value to the taxpayers. It is at odds with the incisive realism required in determining the tax consequences of ambiguous transactions to treat these purchases as “investments” ; they were something else.²⁷

We agree with the trial court and with the Court of Claims in Penn Yan, that the purchase price of the Class C stock (in excess of the nominal value assigned it by taxpayers) is deductible as interest in the year of purchase. Section 163(a) of the Code²⁸ provides, “There shall be allowed as a deduction all interest paid or accrued within the taxable year on indebtedness.” The interest which is deductible under this section is defined as, “the amount one has contracted to pay for the use of borrowed money.”²⁹ As we have noted the Class C stock was without practical value to the taxpayers. Their only reason for acquiring the shares was as a prerequisite for continued borrowing from the Bank. It was in effect a bonus or premium paid in addition to the usual interest, and com'es within the meaning of interest under 163(a)³⁰ The Penn Yan court supported its similar decision with the proposition borrowed from usury eases that:

[I]f as a condition to the making of a loan at an apparently permissible rate of interest, the lender requires the borrower to sell property to him at less than its. value or to purchase property from him at an excessive price, the difference, represents interest. * * *³¹

In M.F.A., the district court held that the amounts paid by the plaintiff cooperative for Class C shares of the St. Louis Bank for Cooperatives were not deductible as interest under § 163(a),³² but allowed a current deduction as an ordinary and necessary business expense under § 162(a).³³ The district court distinguished the cases allowing interest deductions for amounts paid as a bonus or premium to induce a loan,³⁴ since the debtors in those cases received nothing in return for the bonus but the use of the loaned money while the M.F.A. Cooperative had received Class C stock. Because, of the peculiar nature of the Class C shares, we find this distinction unacceptable. As the district court itself observed:

This Class C stock purchased quarterly was of absolutely no use or benefit to M.F.A. Central Cooperative. * * The only reason it was purchased was because M.F.A. Central wanted to borrow money from the St. Louis Bank for Cooperatives and the agreement to purchase Class C stock was imposed as a condition of the loan. It is impossible to separate the loan from the purchase of the stock. One was the motivation for the other.³⁵

The district court in M.F.A. also considered the loan agreement as significant evidence that the parties understood the obligation to purchase the Class C stock to be apart from the interest requirements. We do not feel that the attitude of the parties is controlling. We agree with the Court of Claims in Penn Yan that a current deduction was proper and that the appropriate deduction lies under § 163(a).³⁶ As that court noted this is more logical than the § 162(a) treatment initially given the expenses by the district court in M.F.A., “particularly because the amount of such stock required to be purchased by law and by the loan agreements involved was measured by a percentage of the interest payable on plaintiff's outstanding loan obligations to the bank issuing the stock” ³⁷

Accordingly, the judgment of the district court is affirmed.

1 . 12 U.S.C. § 1141j.

2 . 12 U.S.C. § 1134.

3 . 12 U.S.C. § 11344.

4 . The rate for the New Orleans Bank during the periods in question was 15%.

5 . 12 U.S.O. § 11347(b).

6 . In a footnote to its brief the government states:

The Government also contended in the lower court, that the taxpayers should have reported the patronage dividends (refunds) of shares of Class C stock during the taxable periods in issue as income. The lower court refused to sustain that contention. The Government has not appealed from that part of the judgment.

In this connection the following argument is advanced by amicus curiae:

By failing to appeal from the decision below that Class “C” stock received as patronage refunds must be included in plaintiffs’ income only to fhe extent of $1 per share, the government in effect concedes that the fair market value of such stock is no more than $1 per share. Clearly the same standard must apply in assessing the value of the identical stock which is purchased pursuant to the requirements of a loan agreement.

See Commissioner of Internal Revenue v. Carpenter, 219 F.2d 635 (5th Cir. 1955); Long Poultry Farms v. Commissioner of Internal Revenue, 249 F.2d 726 (4th Cir. 1957); Treas.Reg. § 1.61-5(b) (1) (iv) (1959).

7 . The same question has been involved in two recent cases. In Penn Yan Agway Cooperative, Inc. v. United States, 417 F.2d 1372 (Ct.Cl.1969), the Court of Claims held that amounts paid for Class C shares of the Springfield Bank for Cooperatives under the “interest override” requirements were currently deductible as interest. In M.F.A. Central Cooperative v. Bookwalter, 286 F.Supp. 956 (E.D.Mo.1968), the district court allowed current deduction of the cost of Class C shares in the St. Louis Bank for Cooperatives, but considered it an ordinary and necessary business expense rather than interest. On appeal the Eighth Circuit reversed the district court and held that the cost of Class C shares was not currently deductible. M.F.A. Central Cooperative v. Bookwalter, 427 F.2d 1341 (8th Cir. 1970).

8 . The New Orleans Bank does not issue certificates for the Class C shares. Thus, Class C shares are really only credits entered on the books of the bank in units of $100 and fractional parts thereof.

9 . The Bank’s Class C shares have changed hands only at the liquidation of a cooperative or its merger with another.

10 . 12 U.S.C. § 1134d(c).

11 . For purpose of valuation, the Penn Yan court accepted 30 or 31 years as the period required before the stock would be retired based on the history of the Springfield Bank. It is not clear to what extent this figure reflected the discretion of the bank officials or other factors which could operate to defeat or prolong recovery.

12 . [Fair market value] is the price at which property will change hands between a willing buyer and a willing seller, neither being under any compulsion to buy or sell and both having reasonable knowledge of the facts.

Willow Terrace Dev. Co. v. Commissioner of Internal Revenue, 345 F.2d 933, 936 (5th Cir. 1965).

13 . The Government states in its brief:

In truth, because of the special characteristics of the stock there is no reasonable and determinable market value which can be assigned to it. As one authority puts it [Packel, Law of Cooperatives (3d ed.), Sec. 45 (d) at 234.]:

The circumstances surrounding the issuance of revolving fund certificates are often such that no particular market value can be ascribed to the certificate even though it refers to a sum certain.

14 . The history, organization, and capital structure of the Banks for Cooperatives is discussed by the court in Penn Yan. 417 F.2d at 1373-1376.

15 . Penn Yan Agway Cooperative, Inc. v. United States, 417 F.2d 1372, 1375 (Ct. Cl.1969).

16 . 417 F.2d 1372 (Ct.Cl.1959).

17 . Id. at 1377-1378.

18 . 286 F.Supp. 956 (E.D.Mo.1968).

19 . M.F.A. Central Cooperative v. Bookwaiter, 427 F.2d 1341 (8th Cir. 1970).

20 . From statements contained in briefs filed in this court, it appears that by June 30, 1967 the St. Louis Bank had completely retired its Class A shares and substantially reduced the amount of Class B investment. As a consequence it was able to redeem all Class C shares issued during the fiscal year ending June 30, 1956. The M.F.A. Cooperative had purchased St. Louis Class C shares from other cooperatives, and it appears that transactions between cooperatives were not uncommon.

21 . Rule 52(a) Fed.R.Civ.Pro.

22 . 159 F.Supp. 593, 595, 141 Ct.Cl., 620 cert. denied, 358 U.S. 842, 79 S.Ct. 23, 3 L.Ed.2d 76 (1958).

23 . See Ancel Greene & Co. v. Commissioner of Internal Revenue, 38 T.C. 125 (1962); McMillan Mortgage Co. v. Commissioner of Internal Revenue, 36 T.C. 924 (1961). These cases are thoroughly discussed in Penn Yan. 417 F.2d at 1380-1381.

24 . 417 F.2d at 1379.

25 . See Montana Power Co. v. United States, 159 F.Supp. 593, 141 Ct.Cl. 620 (1958).

26 . See Dresser v. United States, 55 F.2d 499, 512, 74 Ct.Cl. 55, cert. denied, 287 U.S. 635, 53 S.Ct. 85, 77 L.Ed. 550 (1932); Hoppers Co. v. United States, 278 F.2d 946, 949 (Ct.Cl.1960).

27 . Our decision on this point appears to be at odds with that of the Eighth Circuit in M.F.A. Central Cooperative v. Bookwalter, 427 F.2d 1341 (8th Cir. 1970). Insofar as that court’s decision is not attributable to the difference in value of the St. Louis shares, we are simply unable to agree. If we concluded, as did the Eighth Circuit, that the “interest override” payments were made to acquire Class C shares as capital assets, we would agree that recognition of gain or loss must ordinarily await realization through sale or exchange. However, we agree with the court below that, for tax purposes, the bulk of these payments were not actually made to acquire an asset.

28 . 26 U.S.C. § 163(a).

29 . Old Colony R. R. v. Commissioner of Internal Revenue, 284 U.S. 552, 560, 52 S.Ct. 211, 213, 76 L.Ed. 484 (1932).

30 . Wiggin Terminals, Inc. v. United States, 36 F.2d 893 (1st Cir. 1929); L-R Heat Treating Co. v. Commissioner of Internal Revenue, 28 T.C. 894 (1957); Court Holding Co. v. Commissioner of Internal Revenue, 2 T.C. 531, 536 (1943), rev’d on other grounds, 143 F.2d 823 (5th Cir. 1944), court of appeals rev’d and tax court aff’d on other grounds, 324 U.S. 331, 65 S.Ct. 707, 89 L.Ed. 567 (1945). These eases are offered for the same proposition by the Court of Claims in Penn Yan. 417 F.2d at 1379.

31 . 417 F.2d at 1379; quoting, Memorial Gardens of Wasatch v. Everett Vinson & Assoc., 264 F.2d 282, 285 (10th Cir. 1959).

32 . While the Eighth Circuit reversed the district court insofar as it allowed a deduction as a business expense, it adopted the district court’s opinion on the question of interest. M.F.A. Central Cooperative v. Bookwalter, 427 F.2d 1341 (8th Cir. 1970).

33 . 26 U.S.C. § 162(a).

34 . See note 30 supra.

35 . 286 F.Supp. at 961.

36 . The quid pro quo for taxpayer’s present deduction for an interest expense will arise when and if the Class C shares are redeemed. In that event taxpayers must take $99 into ordinary income. J. Chom-mie, Federal Income Tax § 17 at 33 (1968) ; 1 J. Mertens, Federal Income Tax § 7.34 et seq. (1969).

37 . 417 F.2d at 1382.