*197 Decision will be entered for the respondent.
Petitioner, a wholly owned subsidiary, received advances from its parent. The parent paid purchase invoices and petitioner deposited sales proceeds to parent's account. The debits and credits were recorded in open accounts. Periodically, petitioner issued its note for the balance due parent, and canceled the last prior note. The notes were negotiable but were not negotiated. Held, the indebtedness was not "evidenced" by a note and was not borrowed capital within the meaning of section 719 (a) (1), Internal Revenue Code.
*396 FINDINGS OF FACT AND OPINION.
The respondent determined deficiencies in excess profits tax for the calendar years 1942, 1943, 1944, and 1945 in the respective amounts of $ 4,398.39, $ 8,148.53, $ 6,724.69, and $ 10,445.73, and a deficiency in declared value excess-profits tax for 1943 in the amount of $ 38.54.
The primary issue for decision is whether the petitioner is entitled to include as borrowed capital under section 719 (a) (1) of the Internal Revenue Code sums advanced*198 by its parent corporation. If such sums are includible, there is the further issue whether they are to be reduced by indebtedness of the parent company to the petitioner. Certain adjustments made by the respondent are not contested.
A stipulation as to some of the facts, with exhibits, was filed and testimony and further exhibits were introduced at the hearing.
The returns involved were filed with the collector of internal revenue for the district of South Dakota.
FINDINGS OF FACT.
The stipulated facts are so found and the stipulation and exhibits thereto are incorporated by this reference.
The petitioner is a corporation organized and existing under the laws of South Dakota. During the taxable years it was engaged in the wholesale grocery, fruit, and liquor business. Its books were kept on the accrual basis of accounting and its Federal income and excess profits tax returns were made on the basis of a calendar year.
Paxton & Gallagher Co. is a Nebraska corporation having its principal place of business at Omaha, Nebraska. It commenced business in 1864. During the taxable years it was engaged in the wholesale hardware, wholesale grocery, and wholesale liquor business.
At the*199 beginning of 1942, the petitioner's principal place of business and main grocery house was in Deadwood and it had branches in Belle Fourche and Rapid City, all in South Dakota.
On January 20, 1942, Paxton & Gallagher Co. acquired all the outstanding capital stock of the petitioner and continued to hold such stock during the taxable years.
In March 1942, the petitioner's bylaws were amended to provide that its principal office should be in Deadwood and a branch office located at the office of Paxton & Gallagher in Omaha where meetings of directors and stockholders should be held, the corporate books be kept, and corporate business be transacted.
During the taxable years Paul C. Gallagher was president and L. B. Long was secretary-treasurer of both the petitioner and Paxton & Gallagher Co.
*397 Prior to the taxable years Paxton & Gallagher Co. had done business with Chase National Bank of New York and Continental Illinois National Bank and Trust Co. of Chicago, as well as with Omaha banks, for many years and had an excellent credit rating.
L. B. Long, secretary and treasurer of Paxton & Gallagher Co., went to Deadwood, South Dakota, in January of 1942 to close the purchase of petitioner's*200 stock by Paxton & Gallagher Co. Long installed a new manager, R. C. Gridley, and conferred with him and Charles Emerson, vice president of the petitioner, upon methods of operation and financing needed by petitioner because of a contemplated expansion of its business. They considered obtaining from Paxton & Gallagher Co. a straight loan of a flat amount and giving a 12-month note therefor, but decided to provide funds in the amount of petitioner's actual needs.
The plan adopted was that petitioner would forward its purchase invoices and other expense bills to Paxton & Gallagher Co. in Omaha for payment. Petitioner would deposit all collections on sales to the account of Paxton & Gallagher Co. in banks in South Dakota. All intercompany transactions reflecting payments of invoices and expenses and deposits of collections on sales were recorded on petitioner's books. Paxton & Gallagher maintained similar ledger accounts on its books which also reflected all intercompany transactions. At the end of each month petitioner's bookkeeper would forward to Paxton & Gallagher Co. a complete summary of deposits and advances as reflected on the ledger accounts on petitioner's books for reconciliation. *201 Petitioner was to give a note bearing 5 per cent interest for any excess of advances over deposits.
At the end of each month during the taxable years the banks in South Dakota sent Paxton & Gallagher Co. duplicate deposit slips showing petitioner's deposits of cash collections on sales. The totals were recorded on the books of Paxton & Gallagher Co. Payments of purchase invoices and other expenses relating to petitioner's business were also recorded. At the close of January 1942, the books of petitioner and Paxton & Gallagher Co. disclosed that the advances made by Paxton & Gallagher Co. to petitioner exceeded the deposits received from petitioner by the amount of $ 5,662.66. Thereafter petitioner's treasurer, L. B. Long, signed a note in the following form:
January 31, 1942$ 5,662.66
One month after date we promise to pay to the order of Paxton & Gallagher Company Five thousand, six hundred sixty-two and 66/100 Dollars, Payable at Value received with interest at 5 per cent per annum
Adams Brothers Co.
/S/ L. B. Long,
Secretary.
*398 After the close of February 1942, the books showed that the deposits received by Paxton & Gallagher Co. exceeded the advances*202 and Long, as treasurer of Paxton & Gallagher Co., signed a note for the excess in the amount of $ 52,039.21 payable to the petitioner.
After the close of March 1942, the books showed that the deposits exceeded the advances and a new note from Paxton & Gallagher Co. to petitioner for the excess in the amount of $ 52,190.85 was made.
After the close of April 1942, the books showed that the deposits exceeded the advances and a new note from Paxton & Gallagher Co. to petitioner for the excess in the amount of $ 13,317.64 was made.
After the close of May 1942, the books showed that the amounts of advances exceeded the deposits and petitioner issued its note to Paxton & Gallagher Co. for the excess in the amount of $ 31,052.54.
At the end of each succeeding month during 1942 and at the end of each 28-day period during 1943, 1944, and 1945 the amounts of the advances and deposits were ascertained from the records of Paxton & Gallagher. In all these periods the amounts advanced by Paxton & Gallagher exceeded the deposits and the petitioner issued its note to Paxton & Gallagher for the new balance due. All the notes provided for interest at the rate of 5 per cent, and were due either 1 month*203 or 28 days from date. Each time a new note was given the old note was marked "canceled." The notes were kept in a safe in the office of Paxton & Gallagher.
Each year in December the interest accruing was computed and was then included in the amount of advances for December in computing the net amount due Paxton & Gallagher. No interest was charged on the advances until they were incorporated into a note. The indebtedness was shown as "Notes Payable" on petitioner's balance sheets and income tax returns.
On July 1, 1942, petitioner purchased all the assets of Western Liquor Company, a South Dakota corporation. For this purchase Paxton & Gallagher loaned the petitioner $ 184,991.79 for which the petitioner gave its promissory note.
After July 1, 1942, the petitioner conducted a wholesale liquor business under the name Western Wholesale Liquor Company. This business was kept separate from the fruit and grocery business, with separate records and headquarters.
Paxton & Gallagher paid the purchase invoices of the petitioner's liquor division, and collections from that division's sales were deposited to Paxton & Gallagher's account. During 1944 and 1945 the deposits from these sales*204 exceeded the advances made by Paxton & Gallagher. At the close of each 28-day period during those years Paxton & Gallagher gave the petitioner its note for the excess of deposits.
*399 The petitioner had no more than two notes outstanding at any time during the taxable years and did not maintain a notes payable ledger. Paxton & Gallagher Co. did not negotiate any of the notes issued by the petitioner, nor pledge any as security for loans.
The petitioner maintained a ledger account entitled "Paxton & Gallagher Co., Omaha -- Current Account" for each of the grocery and liquor divisions, keeping a running record of advances and deposits. The balances fluctuated almost daily.
In its excess profits tax returns filed for the calendar years 1942 to 1945, inclusive, petitioner computed its excess profits credit based on its invested capital. In its excess profits tax returns for the calendar years 1942 to 1945, inclusive, petitioner claimed an average borrowed capital and an average borrowed invested capital for the years indicated as follows:
| Average | ||
| Average | borrowed | |
| Year | borrowed | invested |
| capital | capital | |
| 1942 | $ 194,901.59 | $ 97,450.80 |
| 1943 | 455,367.34 | 227,683.67 |
| 1944 | 369,522.43 | 184,244.91 |
| 1945 | 305,045.50 | 152,522.75 |
*205 The petitioner had no business purpose in issuing notes to Paxton & Gallagher Co. for the monthly or periodic balances in the accounts between the two companies.
OPINION.
The petitioner, a wholly owned subsidiary of Paxton & Gallagher Co., maintained two open accounts with its parent, one each for its grocery business and its liquor business. The parent advanced money by paying the petitioner's purchase invoices. The petitioner deposited sales receipts to the parent's account. Generally the petitioner owed the parent for advances in excess of sales for the grocery business, while the parent owed the petitioner for an excess of deposits over advances on the liquor business. Each corporation gave the other its note for the separate balance due, without offset for the other account. The notes were made out at the end of each month or accounting period, and kept in a safe. At the end of each period new notes were prepared and signed and the previous notes were marked "canceled." Interest was computed annually and added to the indebtedness.
The petitioner, in its excess profits tax returns for the calendar years 1942 to 1945, inclusive, computed its excess profits credit upon the*206 basis of its invested capital. In this it included as borrowed capital the amounts advanced for the grocery business by its parent, reduced by *400 the amounts shown on the liquor division account as owing from the parent to the petitioner. The respondent determined that these amounts did not qualify as borrowed capital under section 719 (a) (1). 1 The note of $ 184,991.79 given for the purchase of assets of Western Liquor Company was allowed as representing borrowed capital.
*207 As to the monthly or periodic notes, the existence of an indebtedness between the petitioner and its parent is not denied, although the amount thereof is disputed. The principal issue is whether the amounts were outstanding indebtedness "evidenced" by a note. The petitioner's contention is that its indebtedness to its parent was evidenced by the notes. The respondent says the indebtedness was evidenced by open accounts and that the notes were made out and signed solely for the purpose of attempting to qualify the balances as borrowed capital in order to secure a tax benefit.
The petitioner states that since Paxton & Gallagher had long established credit standing with certain New York and Chicago banks and could borrow any needed funds at a better rate than could the petitioner, the arrangement was made that the parent would advance the petitioner funds as needed from day to day rather than have the petitioner borrow on its own credit on a long-term security. Therefore, the petitioner argues, the advances here made were for the purpose of financing its long-term operations in the same manner as a long-term loan or bond issue. The petitioner points out that its note for $ 184,991.79*208 for funds used to buy the assets of Western Liquor Company was treated as borrowed capital and the respondent accepted that treatment.
The tax consequences depend upon what the petitioner did, not upon what it might have done. The petitioner borrowed on a long-term note to buy the liquor company and the amount of that note has been treated as borrowed capital, but the petitioner's day to day operations were financed by advances recorded on open accounts. Indebtedness represented by open accounts does not qualify as borrowed capital for the purpose of section 719 (a) (1). Pendleton & Arto, Inc., 8 T.C. 1302">8 T.C. 1302 (1947); Flint Nortown Theatre Co., 4 T.C. 536 (1945). There was no business reason for giving monthly or periodic notes for the *401 balances from time to time. The parent owned the petitioner and could take over all its assets at any time. The notes were neither negotiated nor pledged as security for loans. There would be no practical value in such a pledge, as the parent's credit, according to the petitioner, was of the highest rank and all the petitioner's assets could be appropriated by the parent. The*209 formality of drawing and signing a note gave the parent nothing it did not already have. The only purpose apparent in doing this was to attempt to qualify the indebtedness on open account as borrowed capital in order to obtain a tax advantage.
The petitioner argues that the day-to-day balances are not involved, that the only indebtedness it claims as borrowed capital is that which was evidenced by the notes. We think the attempted distinction is invalid. The amount of the note was the true balance for a few days and then other charges or credits altered the balance and the note no longer represented the actual indebtedness. Plucked of its feathers the plan employed by the petitioner appears to be little more than a periodic balancing of an open account.
In Kellogg Commission Co., 12 T.C. 182">12 T.C. 182 (1949), the taxpayer sold grain on commission and owed shippers balances which were left on deposit and could be drawn upon at any time. The taxpayer executed promissory notes to its shippers for the balances. From time to time as the balances changed the taxpayer executed new notes, marking the preceding notes "paid." All the notes were retained by the taxpayer*210 for convenience of adjustment. The changes in the balances were not recorded on the notes but only on the ledger and the balance due any shipper could be determined only from the ledger. We held that this indebtedness did not qualify as borrowed capital within the meaning of section 719 (a) (1). The petitioner here attempts to distinguish the Kellogg Commission Co. case. In some respects the case is distinguishable; nevertheless, we think its principle is applicable here. In both cases the amounts of indebtedness were shown on ledger accounts, the amounts fluctuated from time to time, the true amount due at any time could be found only by reference to the ledger, payments were not endorsed on the notes, and the notes served no real business purpose. In the cited case the securing of a tax advantage was admittedly the purpose of the execution of the notes. We perceive no other purpose here.
The notes here do not qualify as borrowed capital. In view of this conclusion it is not necessary to consider whether the amount must be offset by the notes given by the parent to the petitioner.
Decision will be entered for the respondent.
Footnotes
1. SEC. 719. BORROWED INVESTED CAPITAL.
(a) Borrowed Capital. -- The 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 which is evidenced by a bond, note, bill of exchange, debenture, certificate of indebtedness, mortgage, or deed of trust, plus,
* * * *
(b) Borrowed Invested Capital. -- The borrowed invested capital for any day of any taxable year shall be determined as of the beginning of such day and shall be an amount equal to 50 per centum of the borrowed capital for such day.↩