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Leslie v. Commissioner of Internal Revenue

decided: July 15, 1969.

JOHN E. LESLIE AND EVELYN G. LESLIE, PETITIONERS-APPELLEES,
v.
COMMISSIONER OF THE INTERNAL REVENUE, DEFENDANT-APPELLANT



Waterman, Smith and Kaufman, Circuit Judges.

Author: Smith

J. JOSEPH SMITH, Circuit Judge:

The Commissioner of Internal Revenue appeals from a decision of the Tax Court, Charles R. Simpson, Judge, 50 T.C. No. 2. The decision allowed taxpayer,*fn1 a partner in Bache & Co., a brokerage firm, an interest deduction for federal income tax purposes in his return for the taxable year ending January 31, 1959, and held that no part of the firm's indebtedness in the taxable year was incurred or continued "to purchase or carry" tax-exempt securities within the meaning of Section 265(2) Int.Rev.Code 1954, 26 U.S.C. ยง 265(2). We hold that the Commissioner was correct in allocating a portion of the interest to indebtedness so incurred or continued, and reverse the determination of the Tax Court.

Appellee Leslie is a partner of Bache & Co., whose share of Bache's net profits for the 1959 taxable year was 2.75344%. Bache's business consisted of buying and selling, as a broker for its customers, securities and commodity contracts. Bache acquired tax-exempt securities as a dealer for resale to customers, either by purchasing such securities on the open market or through its participation in syndicates that underwrote new issues of tax-exempt securities. In addition, Bache accepted orders from customers for tax-exempt securities. Bache also maintained a market in issues that it underwrote or in which it dealt. It did not encourage investment by the firm in such securities, and the securities were sold as quickly as possible, the house rule being 90 days. Taxexempt obligations constituted less than 1% of the average monthly value of Bache's assets and tax-exempt interest income constituted less than 1/4 of 1% of Bache's gross income. None of the tax-exempt securities owned by Bache was used as collateral for any indebtedness incurred or continued by Bache.

The primary determinant of Bache's bank borrowings was the financing of customers' purchases of securities in margin accounts, and without such accounts receivable from customers there would have been no need for such bank borrowings. The carrying of customers' accounts receivable was essentially a financing transaction in which Bache borrowed funds from banks, securing this indebtedness by a pledge of customers' securities, in order to relend to customers at a higher rate of interest. These lending activities constituted a significant source of profit to Bache.

In Bache's general purpose checking accounts, funds were completely commingled so that the source of such funds could not be traced through the accounts to any particular application of the funds. The amount of money that Bache borrowed from banks was determined on a daily basis. While the purchase, continued ownership, or sale of tax-exempt obligations naturally had an effect on the day-to-day cash requirements of Bache, these transactions were not specifically considered in determining the amount of its bank borrowings. If total disbursements for the day were expected to exceed total receipts, Bache would borrow from banks the amount needed to maintain a reasonable cash position. There was no thought to liquidate some of the tax-exempt securities to reduce the amount which had to be borrowed, since these securities were not held as an investment, but as an incident of the brokerage business -- through participation in syndications, through maintaining a market in tax-exempts, and through purchases for customers.

The total interest expense accrued by Bache on indebtedness was $2,853,271.65, and the total amount of interest income on tax-exempt securities was $58,933.24. The average monthly value of Bache's assets was $168,193,418.94, and the average monthly value of all tax-exempt securities owned by Bache was $1,935,522.67. The average monthly balance of Bache's bank borrowings was $77,661,538.46.

The Commissioner determined that such portion of the claimed interest deduction as was allocable to the firm's investments in tax-exempt securities was non-deductible under Section 265(2).

The Tax Court, in rejecting this argument, correctly notes that Section 265(2) disallows a deduction for interest on indebtedness only when the purpose for which the indebtedness is incurred or continued is to purchase or carry tax-exempt obligations. This is in contrast to Section 265(1) which disallows a deduction for tax-exempt income other than interest by "allocation" to one or more of these sources of income:

Section 265 * * *

No deduction shall be allowed for --

(1) Expenses. -- Any amount otherwise allowable as a deduction which is allocable to one or more classes of income other than interest * * * wholly exempt from the taxes imposed by this subtitle, or any amount otherwise allowable under section 212 * * * which is allocable to interest * * * wholly exempt from the taxes imposed by this subtitle.

(2) Interest. -- Interest on indebtedness incurred or continued to purchase or carry obligations * * * the interest on which is wholly exempt from the taxes imposed by this subtitle. * * * [emphasis added]

The applicable House and Senate reports on proposed amendments to the predecessor to Section 265 indicate that paragraph (2) is not to be applied when the only basis is that an indebtedness may be allocated to the earnings ...


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