*196 Decision will be entered under
Developers and builders advanced funds to water companies and municipalities sufficient to finance extension of water facilities into new real estate projects. The water companies and municipalities gave the developers and builders "water refund contracts" in which the former promised to repay the latter a certain percentage of gross revenues for a specified number of years, or until the principal sum was repaid, whichever occurred first. Although the water companies and municipalities kept records of the ownership status and payments, the contracts did not signify on their faces that such records were being kept nor did they specify or require that they be registered or that transfers thereof be registered upon the obligors' records. Held, (1) the contracts were "evidences of indebtedness" within the meaning of
*723 Respondent determined deficiencies in petitioners' income taxes in the following*197 years and amounts:
| Year | Deficiency |
| 1961 | $ 23,773.87 |
| 1962 | 30,500.74 |
| 1963 | 31,242.41 |
After concession of certain issues by petitioners, only two issues remain for decision:
(1) Whether certain water refund contracts are "evidences of indebtedness" within the meaning of
(2) If this issue is decided affirmatively, whether water refund contracts which were issued before January 1, 1955, were evidences of indebtedness "in registered form" within the meaning of
FINDINGS OF FACT
Those facts which were stipulated are found accordingly, and are incorporated herein by this reference, together with the stipulated exhibits.
Petitioners Ernest A. Wilson and Marjorie Wilson are husband and *724 wife. At the time the petition was filed herein, their residence was Hillsborough, Calif.*198 They filed joint income tax returns for those years with the district director of internal revenue, San Francisco, Calif. Hereafter, Ernest will sometimes be referred to as petitioner.
During 1961, 1962, and 1963, petitioners held certain water refund contracts and received payments thereunder. The amounts received therefrom by petitioners and applied to recovery of cost and the amounts reported as gain in excess of cost were as follows:
| Amount received and applied to recovery of cost | |
| Year | Amount |
| 1961 | $ 79,766.70 |
| 1962 | 63,426.63 |
| 1963 | 86,132.22 |
| Amount reported as gain | |
| Year | Amount |
| 1961 | 1 $ 44,427.64 |
| 1962 | 65,434.92 |
| 1963 | 59,389.60 |
Water refund contracts are executed under the rules of the California Public Utilities Commission in the case of investor-owned public utility water companies in that State or under the rules and regulations of various political subdivisions of governmental bodies in the case of publicly owned water companies. When developers of new subdivisions, housing projects, or industrial tracts request local*199 water companies to supply the new development with water, the rules of the commission or of the governmental bodies require the developer to advance to the water company funds necessary to construct the new facilities and connect the lines of the water company with the distribution facilities for the new development. The funds so advanced are treated by the water company as a liability either under the heading "Advances for Construction" or "Water Rebate Contracts Payable." The new mains and waterlines become the property of the water utility and are ultimately paid for by the utility from its revenues derived from the area. The amount is refunded by the water company to the developer, without interest, pursuant to the terms of the water refund contract.
All of the contracts in this proceeding provide for refunds pursuant to the "percentage of revenue" method. Under this method, the water company agrees to refund the advanced funds by paying to the developer or, as in the present case, his assignee, for a specified number of years, a certain percentage of the company's annual gross revenue derived from customers connected to the extension for which the cost was advanced. Generally, *200 contracts executed prior to October 8, 1954, provided for a refund of 35 percent of such gross revenue for 10 years. Contracts executed subsequent to that date provided for a refund of 22 percent of the revenues for 20 years. Although the repayment *725 terms of some contracts differ in minor respects, and one contract provided for repayment based upon cubic feet of water consumed, they all fall generally within the above-described outlines, and the differences are immaterial for purposes of deciding the issues presented for decision here. The refund payments were made annually, semiannually, or quarterly.
The payments were to cease, according to the contracts, if either the advance was fully paid prior to the expiration of the designated number of years, or upon expiration of the specified number of years. In the latter event, the remaining unpaid balance was treated by the water company as a contribution in aid of construction and of course the holder of the contract could expect no further payments.
Petitioner frequently purchased water refund contracts from the original developers. All of the contracts in question were purchased in the open market for cash. He paid *201 from 25 to 50 percent of the amount refundable at the time of his purchase. Before purchasing a contract, petitioner investigated the company itself, the developer, and the average rate at which he might recover not only his own investment, but also the face value of the contract. The purchase price which petitioner paid was therefore based upon his computations of definitely expected revenue, rather than the face amount. Occasionally petitioner purchased contracts which expired prior to payment of the face amount, but he always recovered his own cost.
Upon acquiring all the water refund contracts involved in this proceeding, petitioner obtained from the seller an assignment of the contract, notified the water company of such assignment and of petitioner's address, received confirmation from the water company of the unpaid balance, that it approved the assignment and that it had recorded such assignment on its books. From that time on, petitioner received the payments due pursuant to the terms of the water refund contract he had purchased. None of the subject contracts bears any inscriptions as to nontransferability, or that the obligor maintains such records. All of the subject*202 contracts are binding upon and inure to the benefit of the successors and assignees of the respective parties and thus assignment is contemplated therein but no specification as to the manner of assignment is set forth or required.
Petitioners reported gain from the payments on their water refund contracts on the cost recovery method, so that gain was only reported after payments received exceeded petitioners' cost. For purposes of this case respondent has no objection to the use of this method.
Petitioners owned seven water refund contracts, involved herein, which were issued before October 8, 1954. The amounts realized over petitioners' investment in those contracts were $ 25,501.38 in 1961, *726 $ 36,796.65 in 1962, and $ 25,309.56 in 1963. Such amounts were reported as long-term capital gain. They also owned 34 water refund contracts, which were issued after October 8, 1954. The amounts realized over their investment in these contracts were $ 18,926.26 in 1961, $ 28,638.27 in 1962, and $ 34,080.04 in 1963. Such amounts were also reported as long-term capital gain.
It is conceded by respondent that the water refund contracts themselves were capital assets in the hands*203 of petitioners. At the time the payments involved herein were received by petitioners, they had held the contracts for more than 6 months.
On November 8, 1962, the California Public Utilities Commission amended its main extension rule. It was resolved that thereafter, with respect to all water refund contracts entered into before November 28, 1962, where 80 percent of the bona fide customers for which the extension was designed were being served therefrom, the water company could negotiate and enter into a new and substitute contract which differed from the original in one respect. If the 80-percent requirement was being met, then any unrefunded balance remaining at the termination date was to be paid in five equal annual installments beginning 1 year after the termination date. Various of the petitioners' contracts issued before November 28, 1962, reached the 80 percent level, and pursuant to the above-described resolution, at least 15 contracts were amended to provide for unconditional payment of any remaining balance at the contract's termination date.
Of the water contracts herein involved, the following were issued before January 1, 1955:
| Water company | Contract date |
| Dominguez Water Corp | Sept. 19, 1951 |
| Dyke Water Co | May 26, 1953 |
| Dominguez Water Corp | June 27, 1953 |
| Las Vegas Valley Water | Oct. 28, 1953 |
| District. | |
| City of Sunnyvale | Dec. 15, 1953 |
| Las Vegas Valley Water | Mar. 3, 1954 |
| District. | |
| Fruitridge Vista Water | Aug. 27, 1954 |
| Co. | |
| Suburban Water | Oct. 11, 1954 |
| Systems. | |
| Suburban Water | Oct. 18, 1954 |
| Systems. | |
| Suburban Water | Oct. 29, 1954 |
| Systems. | |
| Santa Paula Water | Nov. 18, 1954 |
| Works, Ltd. | |
| Suburban Water | Nov. 22, 1954 |
| Systems. | |
| Dyke Water Co | Dec. 27, 1954 |
| Dyke Water Co | Dec. 27, 1954 |
*204 All the water companies which issued the contracts involved herein were either corporations, governments, or political subdivisions thereof.
In his deficiency notice for each year respondent determined that the water refund contract receipts in excess of basis represent ordinary income, not capital gain as reported. Additional income was accordingly determined for each year.
*727 OPINION
The first issue presented for decision is whether the water refund contracts held by petitioners are "evidences of indebtedness" within the meaning of
(a) General Rule. -- For purposes of this subtitle, in the case of bonds, debentures, notes, or certificates or other evidences of indebtedness, which are capital assets in the hands of the taxpayer, and which are issued by any corporation, or government or political subdivision thereof --
(1) Retirement. -- Amounts received by the holder on retirement of such bonds or other evidences of indebtedness shall be considered as amounts received in exchange therefor (except that in the case of bonds or other evidences of indebtedness*205 issued before January 1, 1955, this paragraph shall apply only to those issued with interest coupons or in registered form, or to those in such form on March 1, 1954).
Thus, if the contracts are in fact "evidences of indebtedness" within the meaning of that section, the amounts realized by petitioner above his cost basis will be considered as an amount received in exchange therefor and entitled to capital gain treatment. If they do not qualify, the amounts so realized will be ordinary income instead.
If we decide affirmatively on that issue, we then must decide whether the contracts issued before January 1, 1955, were "in registered form." According to the above-quoted statutory provisions, any contracts issued before that date must be "in registered form" in order to qualify for
Since the parties agreed at trial that the contracts were in fact capital assets, we need not deal with that requirement; there is also no question that the contracts were issued by a corporation, government, or political subdivision thereof. Neither is there any controversy that the amounts received by petitioner were in "retirement" of the contracts.
Evidence of Indebtedness
*206 Respondent contends that the contracts in issue are not evidences of indebtedness because in petitioner's hands they represented nothing more than contingent rights to share in future revenues, if produced. The statute allows preferential treatment to "bonds, debentures, notes, or certificates or other evidences of indebtedness." Urging application of the doctrine of noscitur a sociis, respondent asks us to conclude that we are to interpret the phrase "evidences of indebtedness" from the words that surround it. He cites, inter alia,
Respondent also argues that to be an evidence of indebtedness, the instrument must disclose on its face an unconditional obligation on the part of the obligor to pay a sum certain in money at a fixed or determinable time. He would have us conclude that since the contracts reflect only a contingent right to share in revenues, the contracts do not qualify for
Petitioner, on the other hand, argues simply that each contract was an unconditional promise to pay a fixed amount of money within a designated period, out of a designated source. Citing several cases, *208 he urges that because the debt is to be paid from a designated source does not detract from the essential nature of the contract as an evidence of debt; the parties treated the refund obligation as a debt in the nature of those dealt with by
We find nothing in either
The water refund contracts in question closely resemble bonds or certificates promulgated as a part of fund-raising efforts, and issued by public or quasi-public corporations. Their principal function was to acknowledge formally the *210 advancement of the funds by the obligee, and to outline the repayment procedures and the conditions attached thereto. The additional promises contained in the water refund contracts were secondary in importance to the repayment procedures and conditions and when they were purchased on the open market for cash by petitioners they were merely evidences that the advances therein recited would be repaid. Under all of the facts and circumstances here presented, the contracts in question were very much like revenue bonds or debentures issued to finance the installation of specific facilities.
We agree with respondent that
It is not necessary to attach such labels as bonds, debentures, notes, or certificates to the water refund contracts before us, nor would such a label, if attached, determine the question. The basic element *730 and substance of the water refund contracts in question, however, bear strong resemblance to the underlying and basic elements of the enumerated instruments. The statute before us confers preferred treatment not only on those enumerated instruments, but also on any other "evidences of indebtedness." When the basic nature of the contracts is considered in the light of the statutory language used, *212 we cannot accept respondent's argument or restrict the statutory application as he urges.
The water refund contracts do evidence debts and the various covenants contained in them are not fatal to their status as evidences of indebtedness. They were clearly the evidences of the water companies' debts to repay advances used to finance the expansion of facilities. As noted in our Findings of Fact, the advanced funds were carried by the water companies and municipalities as liabilities on their books. The contracts initially provided for a specified percentage of the annual gross revenues of the company or municipality from the facilities constructed with the advances, to be paid to the obligee, or its assignee, for a specified number of years. All of the 41 contracts involved in this proceeding were definite in those respects. Total repayment of the advanced funds failed only if the specified number of years expired before the advance was repaid and many of the contracts were amended after the California Public Utilities Commission changed its rules in 1962, to provide that any unrefunded balance at the termination date of the contract would be paid in five equal installments in *213 any event.
The water companies and municipalities in question were unconditionally obligated to repay the unpaid balance due when petitioners acquired the contracts as investments on the open market for cash. The amounts to be paid periodically to retire the indebtedness were computed with reference to the set percentage of the gross revenues derived from the facilities built with the advanced funds. If no revenues were produced and the specified period of time elapsed, then the unpaid obligation was discharged and the balance unrefunded was treated by the obligors as a "contribution in aid of construction."
Respondent argues that all of these provisions result in a contingent promise rather than a real obligation and that the refund agreements were merely contractual obligations and not the sort of evidences of indebtedness contemplated by the statute. We do not agree. We conclude and hold that the water refund contracts before us are of the same general type and in the same class as revenue bonds, certificates, or debentures to be repaid from a specified source of revenues and similar thereto so as to be evidences of indebtedness within the meaning of
In
From the standpoint of the taxation of the interest as upon an obligation of the municipality we can see no difference between the income of this bond interest and interest on money lent to a borrower who agrees to pay interest and principal only from the income from his apartment house which he mortgages to secure the loan. [Emphasis supplied.]
* * * *
The Commissioner's cases do not and could not hold that the municipality, in obtaining its general improvements by its bond promises to collect the tax and pay the*216 bondholder from the bond fund, is any the less engaged in borrowing than is one who obtains a loan with a promise to repay it from the income of a specific parcel of the borrower's property which is mortgaged for the debt.
The Commissioner's regulations 2 refer to the debts represented by the instruments enumerated in
Finally, *218 we must determine whether those contracts issued before January 1, 1955, were "in registered form" as required by
As we noted in our Findings of Fact, petitioner obtained assignment of each contract from each seller, notified the water company of the assignment and of his address, and received confirmation from the water company of the unpaid balance, that it approved the assignment, and that it had recorded the assignment on its books. From that time on, petitioner received the payments due from the water company pursuant to the terms of the contract. We also found that none of the contracts bears any inscription or note of any kind as to nontransferability or registration.
The phrase "in registered form" refers to the overall procedure through which the obligation runs only to the registered owner. The primary purpose is to make any unregistered transfers ineffective, and the instrument always so provides on its face. The mere fact that the debtor keeps books of account upon which the debt appears is immaterial without a note of such registration on the face of the instrument.
In
Petitioner cites
We therefore hold that although the contracts were "evidences of indebtedness," they were not "in registered form." Consequently, amounts received in retirement of those issued on or after January 1, 1955, may be considered as received in exchange therefor. Since any contracts issued before that date must be "in registered form" to qualify for
Decision will be entered under
Footnotes
1. All section references are to the Internal Revenue Code of 1954 except as otherwise specified.↩
1. Although this is the reported amount, the parties have stipulated that the gains received in 1961 totaled $ 44,427.66.↩
2. Sec. 1.1232-1. Bonds and other evidences of indebtedness; scope of section.
(a) In general.
Section 1232 applies to any bond, debenture, note, or certificate or other evidence of indebtedness (referred to in this section and §§ 1.1232-2 through 1.1232-4 as an obligation) (1) which is a capital asset in the hands of the taxpayer, and (2) which is issued by any corporation, or by any government or political subdivision thereof. In general,section 1232(a)(1)↩ provides that the retirement of an obligation, other than certain obligations issued before January 1, 1955, is considered to be an exchange and, therefore, is usually subject to capital gain or loss treatment; * * *