Appeals from the District Court of the United States for the Southern District of New York.
Before SWAN, AUGUSTUS N. HAND and FRANK, Circuit Judges.
AUGUSTUS N. HAND, Circuit Judge.
The above three cases are before us on separate appeals by the defendant, the Delaware, Lackawanna and Western Railroad Company, which have been taken from separate judgments in favor of the United States of America and against both defendants in each case for the amount of certain income taxes due from the Warren Railroad Company for the years 1934 and 1935, from the Passaic and Delaware Railroad Company for the years 1934 and 1935, and from the Syracuse, Binghamton & New York Railroad Company for the years 1933, 1934 and 1935. The District Court granted judgments for the plaintiff against the Delaware, Lackawanna & Western Railroad in each case on the theory that it assumed the obligation of its lessors, namely, the Warren Railroad Company, Syracuse, Binghamton & New York Railroad Company and the Passaic and Delaware Railroad Company to pay the income taxes assessed upon those companies for the several years in question. Judgments against the lessors were granted by default.
Perhaps the reasoning of the District Court might be a sufficient basis for upholding the judgments, if the interpretation of the clauses in the leases which provide for payment by the Delaware, Lackawanna and Western Railroad of the lessors' taxes were to be regarded as an entirely new and unsettled problem. But the decisions of the New York and of other courts preclude such an interpretation.
The contractual rights and obligations created by the leases are determined by the law of the place where the engagements were entered into, which was the State of New York. Beale, Conflict of Laws, Vol. II, § 340.1; Restatement Conflict of Laws § 341; In re Barnett, 2 Cir., 12 F.2d 73. It has been universally held both by the courts of New York and other states that a covenant by a lessee to pay the income taxes of the lessor is not within the terms of the contracts unless the obligation is clearly and directly specified. The pertinent provisions and the tax covenants in the leases to the Delaware, Lackawanna and Western Railroad of the three railroads are set forth below in notes*fn1,*fn2 and*fn3
In the Warren lease, article "Fifth" only provides for payment of taxes "imposed upon the premises and property * * * or upon any part or parcel thereof." It does not cover taxes upon the income. In Brainard v. New York Central R.R. Co., 242 N.Y. 125, 151 N.E. 152, 154, 45 A.L.R. 751, the court said that: "Unless the lease expressly provides for the payment of taxes on the income from rentals received under the lease, the imposition of such a burden on the lessee is not justified." Accordingly the Court of Appeals of New York there held that income taxes were not covered by a clause providing that the lessee pay all taxes which might become chargeable on the lessor railroad on its "road or property * * * by reason of its ownership thereof." The government contends that the provisions in Article "Tenth" that the lessee pay all claims against the lessor so that the stockholders shall receive the prescribed rate of interest upon their stock "without any abatement" necessarily covers income taxes but the clause in terms does no more than require payment to the stockholders of their net rentals after paying expenses and taxes on the leased property and does not include such taxes as may be imposed on them as recipients of income unless the imposition is indubitably clear or unless such income taxes are to be withheld by the lessee. Catawissa R.R. Co. v. Philadelphia & R. Ry. Co., 255 Pa. 269, 99 A. 807; Park Building Co. v. George P. Yost Fur Co., 208 Mich. 349, 175 N.W. 431; Young v. Illinois Athletic Club, 310 Ill. 75, 141 N.E. 369, 30 A.L.R. 985. The covenant in Article "Tenth" to pay all claims "for or on account of any matter or thing connected with or relating to the said railroad" fails to cover income taxes which would not relate to the railroad but to its earnings. Woodruff v. Oswego Starch Factory, 177 N.Y. 23, 68 N.E. 994; Boston & Maine R.R. v. Peterborough R.R., 86 N.H. 217, 166 A. 275.
The covenants in the Passaic and Syracuse leases likewise seem insufficient to include income taxes. It is true that the covenants are somewhat broader than in the Warren lease. Taxes "on the business" are not on income of any sort and the railroad business referred to is not that of the lessor but of the lessee which is only running the railroad business on its own account. Rensselaer & Saratoga R.R. Co. v. Delaware & Hudson Co., 168 App. Div. 699, 154 N.Y.S. 739, affirmed 217 N.Y. 692, 112 N.E. 1072; Boston & Providence R.R. v. Old Colony R.R. Co., 269 Mass. 190, 169 N.E. 157; Catawissa R.R. Co. v. Philadelphia & R. Ry., 255 Pa. 269, 99 A. 807. Taxes on the "income or profits of the business" may on first impression, seem to come within the category of income taxes, but again, these taxes are not on the income of the business of the lessors, who are not conducting the business, but on that of the lessee who runs the railroads. McCoach v. Minehill Ry. Co., 228 U.S. 295, 305, 33 S. Ct. 419, 57 L. Ed. 842.
The further clause of the Passaic and Syracuse leases in which the lessee covenants to pay all taxes on the lessors "as a corporation, or on any of its rights, privileges or franchises" also does not include income taxes. Income taxes are not imposed upon the lessors because they are corporations. The clause was intended to cover "franchise taxes." Boston & Maine R.R. v. Wilton R.R. Co., 87 N.H. 416, 181 A. 545. In other words, it was inserted for the purpose of rendering the lessee liable to pay the lessors' excise tax to do business as a corporation and any special excise taxes. Flint v. Stone Tracy Co., 220 U.S. 107, 31 S. Ct. 342, 55 L. Ed. 389, Ann. Cas. 1912B, 1312.
In our opinion an overwhelming weight of pertinent decisions precludes us from holding that the covenants in any of the three leases embrace the income taxes which the United States seeks to recover. A persuasive consideration in support of this conclusion is that all the leases were drawn at a time when there were no income taxes and only in case of the Syracuse lease were such taxes even in prospect. Because there was no agreement between the primary parties to pay income taxes the government can have no claim as a third party beneficiary and, for the same reason, can have no lien on any right of the lessors to require the lessee to pay their income taxes.
Finally, the government seeks to sustain the judgments upon the theory that it has a lien on the rentals accruing under the leases. It can, however, have no right under any theory beyond that of the lessors themselves. In United States v. Western Union Telegraph, 2 Cir., 50 F.2d 102, we said rentals could not be reached because there could be no levy on intangible rights. But since that decision was rendered we have held that the indebtedness of a third party to a taxpayer is subject to distraint and upon demand must be surrendered to the collector by virtue of § 3710, Title 26, U.S.C.A. Int. Rev. Code. United States v. Long Island Drug Co., 2 Cir., 115 F.2d 983. The fact that by the terms of the leases the rentals are to be paid to the shareholders, rather than to the corporate lessors, can make no difference in the result. The rights of the shareholders are derivative and the income is that of the corporation and can only be paid to them by its authority. Here the income was at all times that of the lessor, though under its contract it was directly distributable to the latter's shareholders. Consequently the lessor was subject to liability for all income taxes upon rentals which had accrued. This is made clear in the recent opinion of the Supreme Court in United States v. Joliet & Chicago R.R. Co., 62 S. Ct. 442, 86 L. Ed. , decided January 19, 1942. Our decision in Gold & Stock Telegraph Co. v. Commissioner, 2 Cir., 83 F.2d 465, was to the same effect.
The difficulty with levying upon the rentals prior to their due date is because of the common law rule that a creditor cannot levy upon rent until it becomes payable. But diversion of this rent, which is the only asset from which the income taxes can readily be satisfied, is threatened. To divert it manifestly hinders and delays creditors of the lessors and is a wrong against which a court of equity may relieve them either through an original suit or by so amending the present judgment as to provide that the Delaware, Lackawanna and Western Railroad be enjoined from paying over to the shareholders any rentals accruing under the leases until the income taxes due from the various lessors shall be paid and the collector shall have an opportunity to make a levy on the rentals.
The amended complaints in the above actions set forth claims of two varieties, the first to recover on the covenants which we have discussed and found to be insufficient to include income taxes, and the second to recover because of failure to respond to the notice and demand served by the collector of internal revenue upon the lessee railroad.
The sections of the Internal Revenue Code describing the property subject to lien, distraint and levy and also the liability for failure to surrender property levied upon are §§ 3670, ...