*1365 1. Petitioner purchased municipal bonds on which interest payments were in default and during the taxable years collected the interest which had accrued and defaulted before the date of purchase. Held, such interest payments represent return of capital and are not tax-exempt interest; held, further, interest paid to carry the municipal bonds may not be deducted by petitioner.
2. During the taxable years petitioner made incidental purchases of nongovernmental securities for purposes of investment and speculation. Held, petitioner may not inventory such securities, since it was not, as to them, a dealer in securities.
*203 The respondent has determined deficiencies in income tax for the calendar years 1936 and 1937 in the respective amounts of $307.73 and $1,629.46 and a deficiency in excess profits tax for the latter year in the sum of $177.34, which arise (1) from his disallowance of interest deductions claimed by petitioner in each of the taxable years for interest paid on sums borrowed to purchase*1366 and carry municipal bonds, and (2) from his disallowance of deductions for inventory adjustment in 1937. The petitioner now claims that it erroneously reported as taxable income in each of the years here involved amounts of interest on municipal bonds, collected during these years, which were eccrued and in default at the time it purchased the bonds.
The issues thus raised are (1) whether interest defaulted before the purchase of municipal bonds and collected thereafter is taxexempt and (2), if not, whether interest paid to carry such bonds is deductible despite the provisions of section 23(b) of the Revenue Act of 1936; and (3) whether petitioner was a dealer in nongovernmental securities during the taxable year and thus entitled to inventory such securities. If the last issue is determined affirmatively, then the added question arises as to whether the petitioner may inventory its stock at market or is required to adhere to an alleged earlier election to inventory at cost.
FINDINGS OF FACT.
The petitioner is a corporation organized and existing under the laws of Florida, with its principal office at St. Augustine in that state. Returns for the taxable years were filed*1367 by it with the collector of internal revenue for the district of Florida.
The principal business of the petitioner during the years in question was the purchase of Florida municipal bonds and their resale to customers. Among the bonds thus purchased were many which were in default in interest payments and were bought by petitioner on a "flat" basis, including but not identifying defaulted interest. The petitioner furnished an outlet for bondholders who wished to liquidate such defaulted securities, and it sold to individuals who used such bonds in the payment of taxes to the defaulting subdivision of government which issued them. All municipal bonds were carried on petitioner's books and inventoried at cost, there being no readily ascertainable market price for them.
*204 During the years 1936 and 1937 petitioner collected sums of defaulted interest on municipal bonds, which were attributable to periods prior to its purchase of them, as follows:
| Year | Interest collected on bonds sold by petitioner during year of collection | Interest collected on bonds held by petitioner at end of year of collection | Total |
| 1936 | $345.63 | $720.00 | $1,065.63 |
| 1937 | 2,713.77 | 5,003.72 | 7,717.49 |
*1368 The petitioner included in its income in each of the taxable years the total defaulted interest which it collected in each year. It now claims to have been in error in so doing and asks that these amounts be excluded from income as interest on nontaxable bonds.
The petitioner paid out $2,911 and $2,931.83 in the years 1936 and 1937, respectively, as interest on funds used to purchase and carry municipal bonds. These sums it deducted in its returns for the years in question and such deductions were disallowed by the Commissioner.
Beginning with the year 1936 the petitioner commenced the practice of buying and selling stocks and bonds, other than municipals, for its own account, for purposes of investment and profit. In connection therewith, as an accommodation for investors and speculators in St. Augustine, it purchased stocks and bonds through brokerage houses in Jacksonville for such individuals, charging no commission thereon and realizing no profit therefrom. In a few instances the petitioner resold stocks to customers which it had purchased originally for its own account.
At the close of 1936 the petitioner's securities on hand other than its municipal bonds consisted*1369 solely of 100 shares of stock of Commonwealty & Southern, Inc., which it had bought on December 16, 1936, at $3 5/8 per share, and $15,000 face amount bonds of the Seaboard Airline Railway which it had purchased on December 17, 1936, at $21 1/4. These securities the petitioner carried in its inventory on December 31, 1936, the former at cost and the latter at $18 1/4. The market price of the former on the same date was $3 1/2 and of the latter $21 1/4.
The petitioner on December 31, 1937, inventoried all of its securities except municipal bonds at market value, which was less than cost in the case of each of the securities inventoried. The respondent disallowed this method of inventory, requiring that the securities be restored to cost, thereby increasing the inventory by $8,265.98. The petitioner's books reflect a difference of $8,303.48 between cost over market value for these same securities.
*205 OPINION.
ARUNDELL: There are in substance three issues before us, the first two of which may be disposed of together. Contest arises initially over the taxability of interest payments collected during the taxable years which accrued and were defaulted before petitioner's*1370 purchase of the municipal bonds on which they arose. The petitioner stands on the fact that the payments in question were identified as interest by the payor and that interest on bonds of the type here involved is exempt from Federal income taxation.
Purchase of the bonds in question included in the price paid not only the title to the securities, but the right to receive interest accrued and unpaid. As to the petitioner the whole constituted a capital acquisition and the subsequent payment of the defaulted interest was a return of a portion of his investment, regardless of the label attached by the payor.
This has been, consistently, our position in considering at other times the question here presented, when it related to nongovernment bonds. ; ; affd., ; see ; affd., . The consequence is that such interest payments in those cases were held not taxable as ordinary income but only as capital gain when such was realized.
*1371 These principles have application to nontaxable as well as taxable securities. The petitioner's purchases of the right to receive defaulted interest and its collections under them constitute capital transactions, the gain on which is taxable without regard to the tax-exempt character of the securities. . Under whatever name the payments were made by the municipalities to the petitioner, they were not consideration for the use of funds borrowed from the petitioner but were the return to it of invested funds. The petitioner's argument, therefore, based on the label under which the payments were made by the issuer of the securities, must give way when it becomes apparent that the petitioner has received nothing in the nature of interest but has only recouped a portion of his capital investment. This point was ruled on, adversely to petitioner's contentions, in , but without extended consideration. On the reasoning stated and on the authority of that case, the collections of interest defaulted before petitioner's purchase of the bonds here involved must be held taxable.
*1372 The case of , relied on by petitioner, does not hold otherwise. That case involved an exchange *206 of Virginia debt certificates for bonds of West Virginia. The Circuit Court of Appeals for the Second Circuit held that such exchange resulted in taxable gain to the extent of the value of the West Virginia bonds received in excess of the cost of the certificates turned in therefor. "The balance represents what is received as interest after the purchase, and is exempt." By analogy as nearly as can be made, the accrued interest at the date of purchase formed a part of the petitioner's basis, and only the interest accruing thereafter is to be treated as interest for tax purposes.
Collections of defaulted interest on municipal bonds by the petitioner during the taxable years are, accordingly, to be treated as return of capital, to be taxed as gain when such may be recognized. On the incomplete state of the record here it is impossible to determine with entire accuracy what portion of these collections may be taxed as gain. In our findings, relying on exhibits attached to the petition and the amended answer of the*1373 respondent, we have made division of them dependent on whether the bonds on which they arose were retained by the petitioner at the end of the year of collection. On the failure of the petitioner to show the cost or other basis of bonds sold during the taxable years and thus to furnish facts from which capital gain or loss may be computed, all collections of defaulted interest on bonds which petitioner did not retain at the close of the year of collection must be taxed in their entirety as capital gain. Collections made, however, on bonds retained at the close of the year of collection must be attributed to a partial return of capital, any gain resulting thereon when disposition of the securities is made to be taxed at that time.
The second question, which petitioner seeks to relate to our disposition of the first, is the deductibility of interest paid to carry taxexempt obligations of subdivisions of state government. It is argued that our holding collections of defaulted interest taxable removes the tax-exempt character of the bonds, thus rendering inapplicable statutory denial of the deduction of interest paid on funds borrowed to purchase tax-exempt securities. See section*1374 23(b) of the Revenue Act of 1936. The applicability of the statute to the instant situation is clear. The municipal obligations in question are clearly of the tax-exempt nature there contemplated. There is not included within the tax-exempt features of any such bonds immunity from every tax; capital gain on the sale of governmental securities has been held taxable, , without abridging the essential exemption. Here, from what has been said above, it will be plain also that we have done no more than tax such capital gain and thus in no essential way has the tax-exempt character of the securities carried *207 by the petitioner been violated. Accordingly, the respondent must be sustained in his denial of these interest deductions.
The final question of whether petitioner may inventory its nongovernmental securities at the market price at the close of the year 1937 must be determined on respondent's argument that as to such securities the petitioner is not a dealer and is therefore not entitled to carry them in its inventory at any price. On this point also the respondent must be upheld. *1375 The proof is that petitioner's business was the purchase and reasle to customers of defaulted municipal bonds; that it made incidental purchase of nongovernmental securities for investment and speculation which in a few instances it sold to its customers; that separate from these two activities it accommodates individual investors in St. Augustine by placing their orders for the purchase of securities with Jacksonville brokerage houses, without profit to itself. It is clear that a dealer in securities of limited types may not inventory either securities of other types as to which it is not a dealer, , or securities which it purchases for its own investment purposes. ; ; affd., . The dealings of the petitioner resemble those of the taxpayers in the cases cited. Accordingly, it must be held that it was not a dealer in other than municipal securities and it may not inventory nongovernmental securities held by it at the close of 1937. Loss claimed as arising from readjustment of its*1376 inventory must, therefore, be denied to the petitioner.
Decision will be entered under Rule 50.