*38 Decision will be entered for the respondent.
1. Petitioner purchased all of the outstanding stock of G, a corporation engaged in the small-loan business, in October 1950; it thereupon promptly liquidated G. The purchase price was in excess of G's then net worth, and such excess was paid primarily to obtain G's loans receivable, which had a known average life of 14 months. Included in the purchase contract was a covenant by G's sole stockholder not to compete with petitioner. Held, petitioner is not entitled to an amortization deduction in 1952 with regard to the premium paid for G's loans receivable since the 14-month period had already elapsed prior to that year; held, further, such deduction is not allowable, in the alternative, as a ratable portion of the price allegedly paid for the covenant not to compete.
2. In operating its small-loan business, petitioner required each borrower to subscribe for one of its so-called certificates of investment in a face amount equal to the face amount of his loan. Each borrower signed a term note for his loan and a separate installment note for the certificate, which was pledged as security for the term note. The installment *39 note, in turn, was secured by the borrower's household goods, etc., and was timed to become fully paid when the term note matured. The certificate was then used to discharge the borrower's liability on the term note. Held, that in computing its excess profits credit based on invested capital for 1952 and 1953, petitioner's outstanding certificates do not reflect "borrowed capital" within the meaning of section 439, I.R.C. 1939.
*318 The Commissioner determined the following deficiencies in income tax and excess profits tax of the petitioner:
| Year | Deficiency |
| 1952 | $ 10,346.43 |
| 1953 | 10,544.36 |
The issues presented for our determination are: (1) Whether petitioner is entitled to an amortization deduction in 1952 with regard to an alleged premium paid for intangible assets with a known useful *319 life or, in the alternative, with regard to an amount*40 allegedly paid for a covenant not to compete and (2) whether so-called certificates of investment, issued by petitioner in connection with its small-loan business, reflect "borrowed capital" within the meaning of section 439 of the Internal Revenue Code of 1939.
FINDINGS OF FACT.
Some of the facts have been stipulated and, as stipulated, are incorporated herein by this reference.
Petitioner, a corporation organized and existing under the laws of the State of Georgia, was incorporated on December 15, 1948, as North American Loan and Thrift Company No. 2. In April 1955, its name was changed to North American Finance Corporation of Fulton County. Petitioner is a wholly owned subsidiary of State Loan and Finance Corporation, a Delaware corporation, with its principal office in Washington, D.C.
Petitioner keeps its books and records on the accrual method of accounting and its income has been reported on a calendar year basis. For the taxable years 1952 and 1953, petitioner filed Federal corporate income tax returns with the director of internal revenue for the district of Maryland.
Petitioner's primary business is making small loans to salaried individuals in Atlanta, Georgia.
1. Georgia*41 Finance, Inc. (hereinafter sometimes called Georgia or Georgia Finance), operated a small-loan business in Atlanta, Georgia. Prior to October 21, 1950, all of its outstanding capital stock was owned by W. D. Acker. Acker and Daniel T. Phillips were Georgia's only employees. In 1950, Phillips had been in Georgia's employ for a period of 5 years. Acker and Phillips dealt with Georgia's customers directly, and Phillips knew a number of these customers personally.
In August 1950, petitioner learned that Acker's Georgia stock was for sale. Petitioner attempted to buy Georgia's loans receivable only but Acker refused and insisted rather that petitioner buy all his stock. Accordingly, on October 21, 1950, petitioner agreed to purchase from Acker all the outstanding stock of Georgia. The agreed purchase price was $ 84,977.27.
Georgia's financial position as of October 21, 1950, was as follows:
| Assets: | ||
| Notes receivable: | ||
| Small loans | $ 58,714.63 | |
| Discount loans | 41,638.83 | $ 100,353.46 |
| Cash | 1,669.20 | |
| Total | 102,022.66 | |
| Liabilities and net worth: | ||
| Liabilities | $ 28,552.80 | |
| Net worth: | ||
| Capital stock | $ 56,950.00 | |
| Earned surplus | 16,519.86 | 73,469.86 |
| Total | 102,022.66 |
*42 *320 The sales agreement (dated October 23, 1950) provided, so far as here pertinent:
Second party [Acker] agrees that he will deliver to the first party [petitioner] written resignations of all officers and directors of the corporation, all minute books of the meetings of stockholders and/or directors, all stock books and records, the corporate seal, and any and all other instruments, records and papers in respect to the corporation which may be requested by the said first party.
The second party further covenants and agrees that he will not, prior to November 1, 1952, either directly or indirectly, engage in any business which makes loans of money to individuals in amounts from $ 10 to $ 2,500 in the City of Atlanta, Georgia or at any point within ten miles of the city limits of said city; and further agrees that, unless the first party specifically instructs him to do otherwise, he will keep secret from every person the names of the past, present or prospective borrowers and all other business customers and associates of Georgia Finance, Inc. and that he will not engage or participate in any effort or act to induce any of the borrowers, customers, associates or employees of*43 Georgia Finance, Inc. to take any step which might result to the disadvantage of the first party.
No separate consideration was specified in the contract for Acker's covenant limiting his right to engage in the small-loan business.
At the date of this agreement, Acker resided in Lovejoy, Georgia, approximately 25 miles from Atlanta. After the agreement, Acker operated a farm and had a financial interest in a variety store (near Lovejoy) but never again entered the loan business. He died in 1953, after the expiration of the period covered by the 1950 covenant.
Upon purchase of the Georgia stock, petitioner immediately liquidated Georgia and operated the Georgia loan accounts from its own office. Petitioner thereby acquired 611 active loan accounts.
Phillips thereupon entered the employment of petitioner. His first function with petitioner was to remain at Georgia's office until sometime in November in order to direct the Georgia customers over to petitioner's offices to get the customers "acclimated" to the new location.
In connection with petitioner's assumption of the Georgia loan accounts, letters were sent to all customers of Georgia informing them of petitioner's purchase *44 and of the new address at which their loans were being serviced. Included in the records which petitioner acquired from Georgia were the ledger cards covering inactive accounts, i.e., *321 those on which the balance had been fully paid. In petitioner's business former customers sometimes reborrow from the same lending institution; also, some new accounts are obtained through recommendations by present and former customers.
The loans under consideration were made on a 1-year basis. On the average, customers in petitioner's business in Atlanta renewed their loans about 2.6 times, and the average loan plus its renewals was outstanding about 28 to 29 months. The 611 loan accounts which petitioner acquired from Georgia were not all new customers. Such accounts had been put on the books of Georgia over a period of time. Some of the accounts would be paid up shortly; others would be refinanced and remain on the books over a longer period of time. Petitioner expected that the average life of the 611 accounts acquired from Georgia would be about 14 months or approximately one-half the life of a new account. Its actual experience in fact demonstrated that the average life of such*45 accounts was about 14 months.
Petitioner capitalized the difference between its cost of acquisition of Georgia ($ 84,977.27) and Georgia's October 21, 1950, net worth ($ 73,469.86) as a deferred charge, designated on its balance sheet "Unamortized premiums on loans purchased." 1 By the beginning of 1952, the balance of that item on petitioner's balance sheet was $ 4,804.70. This amount was deducted on petitioner's 1952 Federal income tax return as "Amortized premium on loans purchased." The Commissioner disallowed such deduction.
2. Petitioner's loan business during the taxable years was conducted with members of the working class, who generally were unable to borrow from banks, credit unions, friends, or relatives. They came to petitioner because they were facing a real emergency and were willing "to pay the price" in order to get a loan. *46 A loan thus made by petitioner was limited to 12 months, and the note given to evidence such loan was payable at maturity, 12 months from the date thereof. Such note will hereinafter sometimes be referred to as the "term" note. Interest at the rate of 8 percent per annum was charged on such term note and in practice was deducted from the money lent to the borrower.
In order to obtain a loan from petitioner during the taxable years a potential borrower was required to apply for a so-called certificate of investment (in an amount equal to the amount of the loan) to be issued by petitioner. Such certificates were not issued by petitioner during the taxable years to anyone other than those who borrowed from it, and no loan was made to any borrower who did not pledge such certificate as security for the loan. Petitioner did not make *322 loans to a potential borrower who had assets to pledge as security therefor and for one reason or another was unwilling to subscribe for a certificate.
A prospective borrower would obtain the issuance of a certificate in his name, first, by filing an application therefor and, second, by giving a note to pay for it. Such note had the same maturity*47 as the term note, referred to above, and was secured by a bill of sale on the borrower's household goods, automobile, and other assets; it bore interest at the rate of 8 percent per annum, and was payable in monthly installments. It will sometimes hereinafter be referred to as the installment note.
The form of the subscription and application for a certificate of investment was as follows:
SUBSCRIPTION and APPLICATION
Certificate
No.
North American Loan and Thrift Company
No. 2
32 Broad Street
Atlanta, Georgia
Date
I hereby subscribe for a Certificate of Investment of your Company of the par value shown above and offer in payment therefor a note signed by me and secured by BILL OF SALE ON HOUSEHOLD GOODS, AUTOMOBILE AND co-signed by which said Certificate of Investment, if issued to me, shall be used as collateral security for a loan by your Company in a sum equal to the face amount of said Certificate. I agree to comply with all the provisions of the Charter and by-laws of your Company Witness:
[Amount of Subscription/$ ]
/(Applicant sign here)
To be filled in by office if subscription accepted and application granted:
Total par value $ issued to applicant.
*48 When issued, the certificate bore interest at the rate of 3 percent per annum. In 1952 and 1953 petitioner paid such interest in the aggregate amounts of $ 15,820.81 and $ 19,895.09, respectively. The certificates were qualified with the securities division of the office of the secretary of state of Georgia under Georgia's "blue sky" laws. Petitioner was required to file reports, financial statements, and other records on January 1 and July 1 of each year with the securities division.
Each certificate provided as follows:
This certifies that the holder named above is the owner of an investment in the Company named above, in the sum indicated above, and as such is a member of said Company.
This certificate bears interest at the rate of three (3%) per cent per annum upon the face amount hereof from date of issuance, provided however, no interest *323 shall be paid for less than full monthly periods from date of purchase. Interest shall be paid to the owners thereof on January fifteenth of each year for the period ending December thirty-first of the previous year, or at the time this certificate is repurchased and cancelled, unless the certificate be hypothecated with the Company*49 for a loan, in which event interest shall be paid and credited at the time the loan for which this certificate is hypothecated is paid or settled. Interest shall then be paid on January fifteenth of each year as above provided unless the holder has elected to and does cancel the loan in whole or in part by surrendering this certificate. The Company may apply interest on any certificate to any indebtedness due it by the holder of such certificate. In the event the holder of any certificate which has been hypothecated with the Company for a loan, falls and refuses to pay any indebtedness due to the company for a period of thirty days after its maturity date, then and in that event, such holder shall lose and forfeit his right to receive any and all interest which may have accrued on such Certificate of Indebtedness and no further interest shall accrue thereon until all such indebtedness shall have been fully paid.
The holder or holders of this certificate may borrow from the Company and secure their loan or loans by an assignment of this certificate and at their option may cancel such loan or loans at maturity in whole or in part by surrendering this certificate.
Either the holder*50 or the Company shall have the right to require this certificate to be repurchased by the Company for the face value thereof, together with interest to which said holder is entitled, provided ninety days previous notice be given in writing, which notice may be waived by the Company at its option in specific instances, but in order to safeguard the funds of the Company, its Board of Directors may limit the amount to be purchased in any calendar month.
In addition to the provisions herein set out, this certificate is issued subject to all the provisions of the Charter and By-laws of the Company which are expressly incorporated herein and made a part hereof.
In Witness Whereof, said company named herein, has caused this Certificate to be issued by and through its manager duly authorized in the premises, on the day and year above stated.
The certificateholders had no voting rights and no voice in the management of petitioner.
The issuance of the certificates was directly connected with and was an integral part of the making of loans by petitioner. A typical transaction, involving the making of a 12-month $ 100 loan by petitioner, was as follows:
After the applicant's credit had been approved, *51 he would be first required to sign a subscription and application for a certificate in the amount of $ 100. Then the applicant (and his cosigner) would simultaneously sign two notes -- the term note evidencing the $ 100 loan and the installment note for the certificate. A certificate was then issued in the name of the applicant in the amount of $ 100, which the applicant immediately endorsed on the back to the order of petitioner "as security and collateral" for his loan. Petitioner retained possession of the certificate, which it stapled to the applicant's term note. At the same time, the applicant would sign a bill of sale on his household goods, automobile, and other assets as security for the installment *324 note. At this point, the borrower would be given $ 90 in cash, being the face amount of the loan minus $ 8 interest and minus a so-called service charge of $ 2. Thereafter, the borrower made 12 monthly installment payments in the aggregate amount of $ 108, being the face amount of the installment note plus $ 8 interest. The borrower, in turn, was entitled to $ 3 interest on the certificate. At maturity, the fully paidup certificate would be used to discharge *52 the borrower's liability on the term note. The borrower might have discharged that liability with other funds in the amount of $ 100 and thereby obtained possession of the certificate, but no borrower during the taxable years did so.
When the notes were signed, the cash advanced, and certificates simultaneously issued and pledged, petitioner would record the transaction by "contra" entries in its books of account. Its balance sheets for 1952 and 1953 were as follows:
| North American Loan & Thrift Company No. 2 | ||
| Washington, D.C. | ||
| BALANCE SHEETS | ||
| Year 1953 | ||
| Dec. 31, 1952 | ||
| Amount | Total | |
| ASSETS | ||
| Cash | $ 8,686.55 | |
| Notes receivable | $ 644,778.01 | |
| Less: Reserve for doubtful | 24,179.18 | 620,598.83 |
| Refund due: | ||
| Federal income taxes -- 1951 | ||
| Accounts receivable | 406.31 | |
| Notes receivable -- contra | 781,325.00 | |
| Prepaid advertising | 51.00 | |
| Furniture and fixtures | 11,571.36 | |
| Less: Reserve for depreciation | 4,471.41 | 7,099.95 |
| Deferred charges: | ||
| Unamortized leasehold improvements | 941.80 | |
| Organization expense | 105.75 | 1,047.55 |
| 1,419,215.19 | ||
| LIABILITIES | ||
| Accounts payable | 412.81 | |
| Accrued interest on certificates | 11,719.87 | |
| Accrued taxes: | ||
| Federal and State income taxes | 19,051.86 | |
| Social security taxes | 491.17 | |
| Additional Federal income tax -- 1950-1951 | 12.45 | |
| Additional State income tax -- 1952 | ||
| Personal property taxes | 1,447.00 | 21,002.48 |
| Certificates of investment -- contra | 781,325.00 | |
| Advances from parent company: | ||
| Accounts payable | 355.71 | |
| Notes payable | 458,000.00 | 458,355.71 |
| Deferred income: | ||
| Unearned interest | 47,487.42 | |
| Unearned premiums | 47,443.08 | 94,930.50 |
| Common stock | 25,000.00 | |
| Surplus | 26,468.82 | |
| 1,419,215.19 |
| North American Loan & Thrift Company No. 2 | ||
| Washington, D.C. | ||
| BALANCE SHEETS | ||
| Year 1953 | ||
| Dec. 31, 1953 | ||
| Amount | Total | |
| ASSETS | ||
| Cash | $ 11,108.63 | |
| Notes receivable | $ 654,779.56 | |
| Less: Reserve for doubtful | 24,554.23 | 630,225.33 |
| Refund due: | ||
| Federal income taxes -- 1951 | 81.80 | |
| Accounts receivable | 209.30 | |
| Notes receivable -- contra | 820,295.00 | |
| Prepaid advertising | ||
| Furniture and fixtures | 11,732.96 | |
| Less: Reserve for depreciation | 5,634.37 | 6,098.59 |
| Deferred charges: | ||
| Unamortized leasehold improvements | ||
| Organization expense | 105.75 | 105.75 |
| 1,468,124.40 | ||
| LIABILITIES | ||
| Accounts payable | 389.14 | |
| Accrued interest on certificates | 12,304.43 | |
| Accrued taxes: | ||
| Federal and State income taxes | 28.027.82 | |
| Social security taxes | 263.14 | |
| Additional Federal income tax -- 1950 -- 1951 | ||
| Additional State income tax -- 1952 | 679.57 | |
| Personal property taxes | 1,447.00 | 30,417.53 |
| Certificates of investment -- contra | 820,295.00 | |
| Advances from parent company: | ||
| Accounts payable | 48.02 | |
| Notes payable | 424,404.48 | 424,452.50 |
| Deferred income: | ||
| Unearned interest | 48,295.15 | |
| Unearned premiums | 48,427.26 | 96,722.41 |
| Common stock | 25,000.00 | |
| Surplus | 58,543.39 | |
| 1,468,124.40 |
*54 *325 The daily average amount of the face value of certificates of investment outstanding was $ 737,255.45 for 1952 and $ 802,833.57 for 1953 and such amounts were included by petitioner as part of its "borrowed capital" in computing its excess profits credit to determine adjusted excess profits net income on its returns for such years. The Commissioner disallowed these amounts as borrowed capital. During such years petitioner had available cash, on a daily average basis, from payments made on the installment notes in the amounts of $ 166,293.46 and $ 186,007.35, respectively.
The legal rate of interest for term loans in Georgia during the years in issue was 8 percent.
OPINION.
1. Amortization deduction. -- On its 1952 corporate income tax return petitioner deducted an amount of $ 4,804.70 as "amortized premiums on loans purchased." The Commissioner disallowed this deduction. In its original petition to this Court, petitioner changed its theory in regard to this item and alleged that it was deductible as a ratable portion of an amount paid for a covenant not to compete. By amendment to the petition, petitioner again adopted the theory of the return and alleged, in the*55 alternative, that the item was deductible as part of the amortization of a premium paid for loans purchased with a known life. On brief, petitioner argues only this latter theory.
The facts which give rise to this controversy are set forth in our findings and may be briefly summarized. In October 1950, petitioner purchased all of the issued and outstanding stock of Georgia Finance, Inc., from W. D. Acker for $ 84,977.27. It immediately liquidated Georgia Finance, taking over all the assets and liabilities. The principal assets thus acquired by petitioner consisted of 611 small-loan accounts which petitioner anticipated would be outstanding for an average of about 14 months. Based on the fact that the price paid for the Georgia Finance stock exceeded that corporation's net worth as of the date of purchase, petitioner capitalized an amount of $ 11,444.48 on its books in an account called "Unamortized premiums on loans purchased." On returns filed prior to 1952, petitioner claimed deductions totaling $ 6,639.78 from this account. As noted above, at issue herein is the deduction of the balance of $ 4,804.70 in 1952.
The parties are in agreement that the assets acquired by petitioner*56 upon the liquidation of Georgia Finance had a basis equal to that of the Georgia Finance stock. Kimbell-Diamond Milling Co., 14 T.C. 74">14 T.C. 74, affirmed per curiam 187 F. 2d 718 (C.A. 5), certiorari denied 342 U.S. 827">342 U.S. 827. The parties are not in agreement on the allocation of that *326 basis to the assets acquired and, specifically, as to the proper allocation of the $ 11,444.48 capitalized by petitioner.
While the evidence tends to support petitioner's initial position on its books of account and on its return for 1952 that the amount capitalized was in fact paid as a premium for the 611 loan accounts acquired from Georgia Finance, the short answer is that such theory cannot sustain the disputed deduction in 1952. Petitioner's own evidence indicates that it anticipated when it acquired these 611 accounts that their average life in its hands would be about 14 months, and its actual experience in servicing these accounts in fact verified this expectation. Thus, assuming that petitioner was entitled to amortize the total premium paid therefor, petitioner admits it should have done so over their known *57 life of 14 months. On brief, petitioner states that "the life of the loans receivable was definitely known and therefore capable of being depreciated or amortized over their life of 14 months." Since petitioner purchased the accounts through the purchase of the Georgia Finance stock in October 1950, this 14-month period had fully expired prior to 1952, the taxable year in issue. It follows that on the evidence presented, petitioner is not entitled to any amortization deduction in 1952 with regard to the premium paid for loans purchased.
Nor is petitioner entitled to the deduction on the alternative theory that the amount in question is deductible as a ratable portion of an amount paid for Acker's 2-year covenant not to compete. Assuming that petitioner has not abandoned this alternative point by failing to argue it on brief, it has not proved that either Acker or it regarded any portion of the purchase price of the Georgia Finance stock as payment for the covenant. On the contrary, the evidence presented indicates that the purchase price of the stock was determined on the basis of the value of Georgia Finance's 611 active accounts to petitioner, and that the covenant was added *58 as a matter of routine protection for petitioner as purchaser. Thus, as indicated above, it appears that any value (over Georgia Finance's net worth) paid by petitioner was paid as a premium for the accounts acquired and to some extent possibly to acquire any goodwill inherent in Acker's going business, but to no extent for Acker's covenant not to compete. In these circumstances, no deduction in regard to the covenant not to compete is allowable. Cf. Harold J. Burke, 18 T.C. 77">18 T.C. 77; United Finance & Thrift Corporation of Tulsa, 31 T.C. 278">31 T.C. 278, 285-286, affirmed 282 F. 2d 919 (C.A. 4), certiorari denied 366 U.S. 902">366 U.S. 902; Ray H. Schulz, 34 T.C. 235">34 T.C. 235, 246-250, affirmed 294 F. 2d 52 (C.A. 9).
We hold that the Commissioner did not err in disallowing petitioner's claimed amortization deduction in the taxable year 1952.
2. Borrowed capital. -- In computing the excess profits credit based *327 on invested capital under sections 436-439 of the 1939 Code, a corporate taxpayer is entitled to include 75 percent of its "borrowed*59 capital," as that term is defined in section 439, 2 within its total invested capital. Petitioner included the daily average amount of the face value of its outstanding "Certificates of Investment" within its borrowed capital when computing its invested capital credit. The Commissioner determined that petitioner's certificates do not constitute borrowed capital under the statute.
*60 We consider first the purpose of the invested capital credit which is here in issue. The credit is designed to permit a corporate taxpayer a given rate of return on its invested capital, which is defined to include equity capital, retained earnings, and three-fourths of its outstanding borrowed capital, before the imposition of the excess profits tax. See S. Rept. No. 2679, 81st Cong., 2d Sess., p. 7; Summary of H.R. 9827 "The Excess Profits Tax Act of 1950" As Agreed To By The Conferees, p. 4. Thus, the credit in a sense determines the normal profits of the enterprise, based on the capital invested therein, which should not be considered "excess" for purposes of this special tax on profits.
The question herein is whether petitioner's certificates in fact reflect borrowed capital upon which it is entitled to the statutory rate of return as a part of its excess profits credit. Accordingly, in terms of the definition of borrowed capital in section 439, supra, we must decide whether in substance these certificates represent an "outstanding indebtedness" of petitioner "incurred in good faith for the purposes of the business."
Preliminarily, we note that the status of these certificates*61 under applicable State law is in no way determinative of the litigated question, since we are here applying a definition contained in a Federal statute. Thus, while the form of these certificates may be considered "securities" under Georgia law and petitioner's method of doing business in full compliance with the laws of that State, the true substance of petitioner's certificates and the transactions in which they play a part must be appraised in the light of the statutory definition of borrowed capital in the 1939 Code and the underlying purposes of the invested capital credit in the Federal statute. Cf. Burnet v. Harmel, *328 287 U.S. 103">287 U.S. 103, 110; Morgan v. Commissioner, 309 U.S. 78">309 U.S. 78, 81; United States v. Pelzer, 312 U.S. 399">312 U.S. 399, 402-403; Morris Plan Bank of New Haven v. Smith, 125 F. 2d 440, 441 (C.A. 2); Commissioner v. Valley Morris Plan, 305 F. 2d 610, 619-620 (C.A. 9), rehearing denied 305 F. 2d at 629-630.
Our findings demonstrate the way in which petitioner's certificates were*62 issued and used in its business. All borrowers from petitioner were required to "purchase" such certificates to qualify for a loan from petitioner up to the face amount of the certificates so "purchased." In theory, nonborrowers might also purchase these certificates, but the record affirmatively shows that there were no sales to nonborrowers in the taxable years before us, and there is no evidence that a nonborrower ever purchased such certificates. Indeed, in view of the fact that the installment note executed by the applicant (purportedly for the certificate) bore interest at the stated rate of 8 percent while the certificate in turn paid interest at the rate of only 3 percent, it is difficult to imagine why anyone would ever enter into any such transaction to buy a certificate unless he were economically coerced to do so in order to obtain a loan. As indicated, borrowers signed an installment note at 8-percent interest (pledging their household goods, automobile, and other assets) purportedly in payment for the certificate, which in turn was to bear 3-percent interest per annum, and in every case the borrower then used the certificate as "collateral" to secure the "term" *63 loan (at a separate 8-percent interest) which was the basis for his coming to petitioner in the first place. When the term note came due, the borrower according to plan had made all his payments on the installment note used in theory to pay for the certificate, and in every case the certificate was then used to discharge his indebtedness in a like amount on the term note. Thus, petitioner never gave up possession or control of the certificates in issue. While in theory a borrower had the option to repay his "term" note to petitioner with other funds and take possession of the certificate as an investment returning 3 percent per annum, no borrowers elected to do this. The net effect of coupling certificates with all small loans made by petitioner was to require the borrower to sign two notes to petitioner instead of one for each loan he needed and thereby to pay a net total of interest vastly in excess of the purported 8 percent. 3 It also had the effect of requiring the *329 borrower to repay his loan to petitioner in installments, so that petitioner had the use of part of the funds lent its borrowers continually during the terms of their loans.
*64 In these circumstances, looking to the substance of petitioner's small-loan transactions and not merely their form, we think that petitioner's certificates in no real sense represented an indebtedness of petitioner to its customers. These customers were described at the trial herein by petitioner's vice president as persons "who can't make loans or can't obtain money from banks, credit unions, friends, or relatives. They come to us because they are facing a real emergency. They are willing to pay the price to get the money if they can." Petitioner would have us believe that such persons, at the instant they borrow money from petitioner, immediately lend a like amount of money back to petitioner on its certificates. We can accept no such fiction. Petitioner's customers are borrowers; they are neither lenders nor investors. They have no funds to lend to petitioner's business or to anyone else. They come to petitioner because they need funds, and their need is sufficient that they are willing to pay the price exacted from them through the medium of these inextricably interrelated transactions in order to obtain their loans. To paraphrase the language of the Supreme Court in Griffiths v. Helvering, 308 U.S. 355">308 U.S. 355, 357,*65 giving effect to the substance of a transaction rather than to its form: That is the crux of the business to petitioner, and that is the crux of the business to us.
In reality in every case the money paid by petitioner's borrowers on the installment note constituted merely a partial repayment of the money lent by petitioner to the borrowers. In no case did this money represent new capital lent to petitioner. In substance it represented a small portion of a revolving fund of money lent by petitioner to its borrowers on one note and returned by its borrowers in the form of installment payments on a separate note. The record fails to show that petitioner borrowed a single penny of additional capital through its certificates in 1952 and 1953. 4 We hold, therefore, that petitioner's certificates do not in fact constitute borrowed capital as defined in section 439, supra.
*66 *330 On brief petitioner presses the point that it "conducted its business in accordance with the specific requirements of the Georgia law and it cannot be said that its method of conducting its business was a sham or was for the purpose of avoiding Federal income tax." Granted all this be true, petitioner's position herein is not improved. We pass no judgment on the Georgia statute under which petitioner conducts its business nor on the Georgia cases, cited by petitioner, which appear to hold that such business does not violate the usury laws of that State. While there was some general testimony at the trial of this case to the effect that a small-loan business such as that conducted by petitioner could not have been operated profitably at the legal rate of interest of 8 percent per annum in Georgia, we do not consider such evidence controlling. Neither the legality nor the propriety of petitioner's use of its certificates is before us. We are concerned only with the substance of these certificates for purposes of applying the definition of borrowed capital in the Federal statute. 5*69 On the evidence before us, we think it clear that petitioner did not in fact intend to *67 borrow money from its customers by the use of its certificates, and certainly its customers did not in fact intend to lend petitioner money by the use of such certificates. On the contrary, the facts show that in every case the substance of the transaction was that petitioner was the lender and its customer was the borrower. The use of the many forms which played a part in this process, the application blank for the certificate, the certificate itself, the installment note in purported payment for the certificate, the term note upon which the customer finally obtained his loan, all were part and parcel of but a single transaction, the lending of money by petitioner to its customers at a profit. "A given result at the end of a straight path is not made a different result because reached by following a devious path." Minnesota Tea Co. v. Helvering, 302 U.S. 609">302 U.S. 609, 613. 6 In reality, the certificate together *331 with the installment note which was used by the customer to obtain the certificate represented nothing more than a means by which the customer was to repay his loan from petitioner by installments during the term of the loan. Petitioner*68 obtained no new, added capital by the use of these forms; it obtained only the repayment of the money it had lent to its customers, with additional interest as an added, important feature. Thus, we conclude that in substance petitioner's certificates do not represent an outstanding indebtedness of the corporation within the meaning of the Internal Revenue Code.
However, even if we were persuaded that these certificates were true debts of petitioner, we think that*70 these particular certificates still would fail to meet the statutory definition of borrowed capital. Petitioner's liability on all of these certificates was at best contingent upon the borrower paying the term note for which they served as "collateral," and in practice the latter note was paid only if the borrower made timely payments on his installment note given in payment for the certificate. As a contingent liability, it is clear that no "outstanding indebtedness" existed as required by the statutory definition of borrowed capital. Cf. Frazer-Smith Co., 14 T.C. 892">14 T.C. 892, 899-900; C. L. Downey Co., 10 T.C. 837">10 T.C. 837, 839-840, affirmed 172 F. 2d 810, 812 (C.A. 8). Thus, in form as well as in substance, the certificates in issue fail to qualify as borrowed capital. We hold that the Commissioner correctly refused to allow the inclusion of any value for these certificates in the determination of petitioner's allowable invested capital credit.
Decision will be entered for the respondent.
Forrester, J., dissenting: I fully agree with the majority that since we are here applying a definition*71 (of borrowed capital) contained in a Federal statute, our consideration of the problem is not terminated by the fact that these certificates do so qualify under Georgia law.
I fully disagree with the majority's statement, "the status of these certificates under applicable State law is in no way determinative of the litigated question," (emphasis supplied) for it is not disputed that strict compliance with that very State law was a prerequisite to realization by this petitioner of more than 8-percent interest.
We are here dealing with a tax on income, and absent this method of doing its business, in compliance with the State law, petitioner's *332 income would have disappeared, or at least have been greatly reduced. 1
*72 The broad Congressional purpose behind the enactment of the borrowed capital provision of the excess profits credit based on invested capital is clear. It is to provide relief by means of a credit for 75 percent of funds procured by borrowing which were actually used in the business in order to produce further taxable income. The Senate Finance Committee stated (S. Rept. No. 2679, 81st Cong., 2d Sess., p. 10 (1950)):
Borrowed capital, under your committee's bill, is indebtedness (but not including interest) which is evidenced by a bond, note, bill of exchange, debenture, certificate of indebtedness, mortgage, deed of trust, bank loan agreement, or conditional sales contract. This is substantially the same definition as appears in the House bill. However, your committee's bill limits the amount to be considered as borrowed capital to outstanding indebtedness "incurred in good faith for the purposes of the business." * * * [Emphasis supplied.]
See also Summary of H.R. 9827 "The Excess Profits Tax Act of 1950" prepared by the staff of the Joint Committee on Internal Revenue Taxation, sec. 5 (c), p. 6, providing in part:
Definition of borrowed capital. -- Borrowed capital*73 is indebtedness * * * which is evidenced by a * * * certificate of indebtedness * * *. However, the amount to be considered as borrowed capital is limited to outstanding indebtedness "incurred in good faith for the purposes of the business." * * * [Emphasis supplied.]
and section 40.439-1(d), Regs. 130, which reads: "In order for any indebtedness to be included in borrowed capital it must be incurred in good faith for the purposes of the business and not merely to increase the excess profits credit. [Emphasis supplied.]"
It seems clear to me that during the years in issue petitioner had available cash on a daily average basis in the amounts of $ 166,293.46 and $ 186,007.35 which had been paid in by the certificateholders in cash. Respondent argues that these amounts were simply the daily average of the amounts paid on the installment notes and therefore entitled to no credit.
I feel that respondent's analysis is superficial. Of course, these amounts were what had been paid in on the installment notes, but in a very real sense they were something more; they were the holders' equities in the certificates at any given time and petitioner actually had these amounts of cash*74 on hand which it could, and did, lend to *333 new borrowers. These same amounts were also represented by petitioner's net liabilities (after all offsets) on the certificates, and it is these net liabilities which I feel do qualify as a part of the borrowed capital credit.
The main reliance of the majority in allowing petitioner no credit on the certificates is expressed: "'A given result at the end of a straight path is not made a different result because reached by following a devious path.' * * *" The following cases are cited: Minnesota Tea Co. v. Helvering, 302 U.S. 609">302 U.S. 609, 613; Starr v. Commissioner, 82 F. 2d 964 (C.A. 4), certiorari denied 298 U.S. 680">298 U.S. 680; Helvering v. Elkhorn Coal Co., 95 F. 2d 732 (C.A. 4); Kimbell-Diamond Milling Co., 14 T.C. 74">14 T.C. 74, affirmed per curiam 187 F. 2d 718 (C.A. 5), certiorari denied 342 U.S. 827">342 U.S. 827; S. Nicholas Jacobs, 21 T.C. 165">21 T.C. 165, affd. 224 F. 2d 412 (C.A. 9); Virginia W. Stettinius Dudley, 32 T.C. 564">32 T.C. 564,*75 affirmed per curiam 279 F. 2d 219 (C.A. 2); but a critical examination of these cases reveals that in each, the identical result as was attained could have been reached by a direct method but would have resulted in more taxes being payable. As expressed by the Supreme Court in Minnesota Tea Co. v. Helvering, supra at 613:
The conclusion is inescapable, as the court below very clearly pointed out, that by this roundabout process petitioner received the same benefit "as though it had retained that amount from distribution and applied it to the payment of such indebtedness." * * * The preliminary distribution to the stockholders was a meaningless and unnecessary incident in the transmission of the fund to the creditors, all along intended to come to their hands, so transparently artificial that further discussion would be a needless waste of time. * * *
I therefore regard these cases as inapposite here where more than 8-percent interest could not have been realized by petitioner absent the certificates.
I would hold therefore that such daily average amounts ($ 166,293.46 in 1952 and $ 186,007.35 in 1953) are within the*76 spirit and purpose of section 439 (b)(1) and that such amounts are allowable as a part of petitioner's borrowed capital.
Footnotes
1. The amount actually capitalized was only $ 11,444.48. The $ 62.93 difference between this amount and the $ 11,507.41 paid in excess of Georgia's book value is unexplained.↩
2. SEC. 439. BORROWED CAPITAL.
(a) Average Borrowed Capital. -- For the purposes of this subchapter, the average borrowed capital for any taxable year shall be the aggregate of the daily borrowed capital for each day of such taxable year, divided by the number of days in such taxable year.
(b) Daily Borrowed Capital. -- For the purposes of this subchapter, the daily borrowed capital for any day of any taxable year shall be determined as of the beginning of such day and shall be the sum of the following:
(1) The amount of the outstanding indebtedness (not including interest) of the taxpayer, incurred in good faith for the purposes of the business, which is evidenced by a bond, note, bill of exchange, debenture, certificate of indebtedness, mortgage, deed of trust, bank loan agreement, or conditional sales contract. * * *↩
3. Adverting to the example set forth in the findings, the maker of the $ 100 1-year term note was given $ 90 in cash, after deducting $ 8 in interest and $ 2 as a so-called service charge. Assuming that the $ 2 service charge was bona fide and did not include any further hidden interest, cf. Western Credit Co., 38 T.C. 979">38 T.C. 979, the borrower actually received a loan of at most $ 92, although he gave a term note in the face amount of $ 100 therefor. He discharged his liability on that note by paying $ 108 on the installment note. And since the certificate issued in respect of the installment note paid him $ 3, he made net payments in the amount of $ 105 to discharge what in effect was a $ 92 loan. Thus, the cost to him of that $ 92 loan was $ 13. Assuming that he had had the use of the $ 92 for the full 12-month period, the true rate of interest in fact paid by him would be somewhat in excess of 14 percent. But the borrower did not have the full use of that money over the 12-month period, in view of the installments paid by him during the course of the year. When this factor is taken into account, the true rate of interest, considering the transaction as a whole, is closer to 28 percent. And if the $ 2 service charge is regarded as additional interest (cf. Western Credit Co., supra↩), the true rate of interest would be even higher.
4. No question is here presented as to whether any interest incorporated in the installment payments resulted in retained earnings which increased petitioner's invested capital. The sole issue is whether petitioner is entitled to a credit for "borrowed capital" in accordance with section 439↩.
5. In this regard we think particularly revelant what was said recently by the Court of Appeals for the Fifth Circuit in United States v. General Geophysical Company, 296 F. 2d 86, rehearing denied 296 F. 2d 90, certiorari denied 369 U.S. 849">369 U.S. 849, rehearing denied 369 U.S. 891">369 U.S. 891. The court stated (296 F. 2d at 90):
"The taxpayer asserts that the transactions were prompted by a valid business purpose and were effected without a motive of tax avoidance. We accept these assertions, which are supported by the trial judge's findings, as true. They lend support to the taxpayer's case, but they do not control the disposition of the case. Intent often is relevant in questions of taxation, particularly where the bona fides of a transaction is called into question, but in most cases tax treatment depends on what was done, not why it was done."↩
6. Minnesota Tea is but one of a vast number of cases in a wide variety of Federal tax problems where the separate, formal steps, constituting merely components of a single transaction, were synthesized to arrive at the substance of the transaction and the tax consequences flowing therefrom. Cf., e.g., Starr v. Commissioner, 82 F. 2d 964 (C.A. 4), certiorari denied 298 U.S. 680">298 U.S. 680; Helvering v. Elkhorn Coal Co., 95 F. 2d 732 (C.A. 4); Kimbell-Diamond Milling Co., 14 T.C. 74">14 T.C. 74, affirmed per curiam 187 F. 2d 718 (C.A. 5), certiorari denied 342 U.S. 827">342 U.S. 827; S. Nicholas Jacobs, 21 T.C. 165">21 T.C. 165, affirmed 224 F. 2d 412 (C.A. 9); Virginia W. Stettinius Dudley, 32 T.C. 564">32 T.C. 564, affirmed per curiam 279 F. 2d 219↩ (C.A. 2).
1. The majority state that there was some "general testimony" to the effect that petitioner's business could not have been operated profitably at the legal rate of interest of 8 percent per annum in Georgia. In my view this testimony was convincing. It was by petitioner's vice president and general counsel as follows:
"We would stay in business just about one month, because we would lose money so fast. You can't loan money on installments, and take those myriad of detailed transactions, at any 8% interest rate. You wouldn't be in business 30 days. Mr. Acker wasn't making any money at 18%."↩