FITZGERALD MOTOR CO. v. COMMR. OF INTERNAL REVENUE

RAUM, Judge:

The Commissioner determined deficiencies in income tax as follows: Docket No. Petitioner TYE Amount July, 31 — { 1966 $684.34 2135-72 .......... Fitzgerald Motor Co., Inc. ..... { 1967 722.46 { 1968 2,081.56 { 1966 1,039.54 2136-72 .......... Loans, Inc. .................... { 1967 1,046.15 { 1968 2,300.38 At issue is the propriety of the Commissioner's action under section 482 of the 1954 Code in allocating additional income to petitioners in respect of loans to brother-sister corporations that were interest-free or at less than arm's-length rates of interest. The facts have been stipulated.

Petitioner Fitzgerald Motor Co., Inc. (Fitzgerald) was a Georgia corporation engaged in the retail automobile business. Petitioner Loans, Inc. (Loans), also a Georgia corporation, was engaged in the business of providing financing on automobiles sold by Fitzgerald. Each petitioner's books and records were maintained on an accrual basis of accounting and their Federal corporate income tax returns were filed on a fiscal year ending July 31. Their respective tax returns for each of the taxable years ending July 31, 1966, and July 31, 1967, were filed with the district director of internal revenue at Atlanta, Ga., and their returns for the taxable year ending July 31, 1968, were filed with the Southeast Service Center at Chamblee, Ga. At the time their petitions herein were filed, the principal office of both corporations was in Fitzgerald, Ga.

At all times relevant hereto, the sole stockholder of both Fitzgerald and Loans was one B. I. Anderson. Anderson also owned all of the stock of Dixie Peanut Co., Inc. (Dixie), a Georgia corporation operating as a wholesale dealer in peanuts and corn, and he served as president and chairman of the respective boards of directors of all three corporations. Dixie was an accrual basis taxpayer and filed Federal corporate income tax returns on a calendar year basis.

Prior to and during the tax period in issue, Fitzgerald made advances to Dixie, and Loans made advances to both Fitzgerald and Dixie. The table below sets forth the balances in the intercompany loan accounts as of July 31 of each year shown: Owed to Owed to Loans Owed to Loans Year Fitzgerald by by Fitzgerald by Dixie Dixie 1968 ................ $182,689.73 $80,199.80 $21,805.86 1967 ................ 174,933.07 74,499.41 21,805.86^fn1 1966 ................ 169,783.66^fn1 71,304.90 21,805.86^fn1 1965 ................ 169,521.16 62,935.89 21,805.86 1964 ................ 188,058.40 39,368.93 21,805.86 1963 ................ 181,843.31 46,975.91 21,805.86 1962 ................ 181,043.91 27,690.44 21,805.86 1961 ................ 175,923.70 28,693.01 16,000.00 1960 ................ 76,840.07 25,507.60 10,000.00 1959 ................ 67,829.92 30,565.40 10,000.00 1958 ................ 59,584.35 36,633.44 10,000.00 1957 ................ 52,380.82 13,900.45 10,000.00 1956 ................ 45,432.46 4,225.05 _______________ 1955 ................ 30,572.13 8,789.97 _______________ 1954 ................ 18,141.55 27,499.99 _______________ 1953 ................ 3,655.98 21,279.65 _______________ 1952 ................ 991.06 1,472.78 _______________ 1951 ................ 8,782.91 _______________ _______________ No notes or loan agreements were made in respect of the advances shown in the foregoing table. The stipulated materials fail to establish the rates or amounts of interest, if any, called for, or in fact paid, upon the indebtedness, nor does the record disclose the purposes for which the loans were made or the uses to which the proceeds were put by the borrowers.

Both Fitzgerald and Loans were operated at a profit in each of the taxable years in issue, but Dixie sustained a net operating loss in each of the years 1966-68. Dixie's corporate charter provided that the corporate objective was "pecuniary benefit to the shareholders." The following table represents a summary of data contained in the income tax returns of Fitzgerald, Loans, and Dixie: Fitzgerald — TYE July 31 — ------------------------------- 1966 1967 1968 Gross receipts .................... $477,816 $552,485 $508,652 Cost of goods sold ................ (400,357) (477,751) (433,693) ------------------------------------ Gross profit ...................... 77,459 74,734 74,959 Finance charges ................... 3,534 6,033 4,666 Other interest .................... 5,027 6,086 5,597 Miscellaneous income .............. 2,423 2,821 2,739 ------------------------------------ Total income .................. 88,443 89,674 87,961 Interest expense .................. (4,920) (6,528) (4,279) Net operating loss deduction ...... __________ __________ __________ Other deductions .................. (71,576) (73,170) (67,054) ------------------------------------- Taxable income ................ 11,947 9,976 16,628 Loans — TYE July 31 — ------------------------------- 1966 1967 1968 Gross receipts .................... _______ _______ _______ Cost of goods sold ................ _______ _______ _______ ------------------------------------ Gross profit ...................... _______ _______ _______ Finance charges ................... $8,462 $8,528 $8,621 Other interest .................... _______ _______ _______ Miscellaneous income .............. 262 32 _______ ------------------------------------ Total income .................. 8,724 8,560 8,621 Interest expense .................. _______ _______ _______ Net operating loss deduction ...... _______ _______ _______ Other deductions .................. (4,535) (5,834) (3,403) ------------------------------------ Taxable income ................ 4,189 2,726 5,218 Dixie — TYE Dec. 31 — ------------------------------- 1966 1967 1968 Gross receipts .................... $1,408,465 $930,521 $1,119,090 Cost of goods sold ................ (1,229,203) (812,663) (1,049,769) ------------------------------------- Gross profit ...................... 179,262 117,858 69,321 Finance charges ................... _________ _________ ________ Other interest .................... _________ _________ ________ Miscellaneous income .............. 923 523 234 ------------------------------------- Total income .................. 180,185 118,381 69,555 Interest expense .................. (47,267) (40,231) (46,520) Net operating loss deduction ...... (2,629) (44,850) (95,532) Other deductions .................. (175,139) (128,832) (129,148) ------------------------------------- Taxable income ................ (44,850) (95,532) (201,645) The following table represents a summary of the data contained in each corporation's yearend balance sheets: Fitzgerald — balances as of July 31 — ------------------------------------------ 1965 1966 1967 1968 Assets: Cash .................... $150,921 $169,449 $145,535 4158,032 Notes and accounts receivable ............ 66,647 73,012 79,281 87,784 Inventories ............... 118,831 155,608 117,581 163,470 Prepaid expenses .......... 907 ________ ________ ________ Buildings and fixed depreciable assets (less accumulated depreciation) ........... 5,456 5,612 4,275 3,697 Land ...................... ________ ________ ________ ________ Other investments ......... ________ ________ ________ ________ Amounts due from affiliates .............. 179,693 180,214 198,431 194,876 Amounts due from stockholder ............. ________ ________ ________ ________ --------------------------------------------- Total assets ......... 522,455 583,895 545,103 607,859 ============================================= Liabilities and capital: Accounts payable ........ 9,761 6,487 5,381 6,868 Amounts due to affiliates ............ 76,477 87,665 90,812 96,282 Amounts due to stockholder .......... 25,211 25,320 21,053 14,60 Other current liabilities ........... 189,363 233,383 189,035 238,487 Capital stock ........... 50,000 50,000 50,000 50,000 Earned surplus .......... 171,643 181,040 188,822 201,582 --------------------------------------------- Total liabilities and capital ......... 522,455 583,895 545,103 607,859 ============================================= Loans — balances as of July 31 — ------------------------------------------ 1965 1966 1967 1968 Assets: Cash .................... $7,098 $7,100 $6,163 $72 Notes and accounts receivable ............ 60,731 52,093 50,454 46,386 Inventories ............... ________ ________ ________ ________ Prepaid expenses .......... ________ ________ ________ ________ Buildings and fixed depreciable assets (less accumulated depreciation) ........... ________ ________ ________ ________ Land ...................... ________ ________ ________ ________ Other investments ......... 3,000 3,000 3,000 3,000 Amounts due from affiliates .............. 90,633 101,129 105,445 111,739 Amounts due from stockholder ............. 1,026 1,026 1,026^fn1 1,125 --------------------------------------------- Total assets ......... 162,488 164,348 166,088 162,322 ============================================= Liabilities and capital: Accounts payable ........ 632 516 597 484 Amounts due to affiliates ............ 369 369 369 369 Amounts due to stockholder ........... ________ ________ ________ ________ Other current liabilities ........... 11,028 9,738 9,270 1,489 Capital stock ........... 25,000 25,000 25,000 25,000 Earned surplus .......... 125,459 128,725 130,852 134,980 --------------------------------------------- Total liabilities and capital ......... 162,488 164,348 166,088 162,322 ============================================= Dixie — balances as of Dec. 31 — ------------------------------------------ 1965 1966 1967 1698 Assets: Cash .................... $361,138 $319,909 $330,746 $349,549 Notes and accounts receivable ............ 964 1,081 6,516 1,110 Inventories ............... 1,573,474 1,165,977 1,442,682 1,184,611 Prepaid expenses .......... 3,500 3,500 3,500 3,500 Buildings and fixed depreciable assets (less accumulated depreciation) ........... 84,461 117,250 137,471 175,738 Land ...................... 750 750 750 750 Other investments ......... ________ ________ ________ ________ Amounts due from affiliates .............. 17,238 19,517 45,678 ________ Amounts due from stockholder ............. ________ ________ ________ ________ --------------------------------------------- Total assets ......... 2,041,525 1,627,984 1,967,343 1,715,258 ============================================== Liabilities and capital: Accounts payable ........ 5,127 16,712 15,324 34,090 Amounts due to affiliates ............ 226,375 231,502 252,118 291,690 Amounts due to stockholder ........... 395,812 406,931 418,547 450,546 Other current liabilities ........... 1,260,263 861,112 1,220,309 984,000 Capital stock ........... 100,000 100,000 100,000 100,000 Earned surplus .......... 53,948 11,727 (38,955) (145,068) ---------------------------------------------- Total liabilities and capital ......... 2,041,525 1,627,984 1,967,343 1,715,258 ==============================================

In his separate deficiency notices to Fitzgerald and Loans, the Commissioner determined:

that interest income reported on your return for each year involved herein is understated by the amount shown below, which amount constitutes the arm's length interest that should have been charged by you on monies advanced by you to * * * corporations owned or controlled by the same interests. Under the authority of section 482 of the 1954 Code, additional gross income is allocated to you as shown below. It is determined that this allocation is necessary to prevent the evasion of taxes and to clearly reflect your income and the income of [the corporations to which amounts were advanced] * * *

The additional interest income referred to above was computed by the Commissioner in the respective deficiency notices as shown in the following tables: Fitzgerald — TYE July 31 — ---------------------------------------- 1966 1967 1968 Average monthly balance of advances made by Fitzgerald to Dixie ...................... $169,713.00 $173,178.00 $180,070.00 Appropriate interest rate ....... 5% 5% 5% Interest income earned by Fitzgerald as corrected ....... $8,485.64 $8,658.90 $9,003.58 Amount reported ................. $5,375.00 $5,375.00 $3,875.00 ----------------------------------------- Additional interest income earned by Fitzgerald on advances to Dixie ............. $3,110.64 $3,283.90 $5,128.58 Loans — TYE July 31 — -------------------------------------- 1966 1967 1968 Average monthly balances of advances made by Loans to: Fitzgerald .................... $72,693.00 $73,293.00 $77,243.00 Dixie ......................... $21,806.00 $21,806.00 $21,806.00 Appropriate interest rate ....... 5% 5% 5% Additional interest income earned by Loans on advances to: Fitzgerald .................... $3,634.87^fn1 $3,664.96 $3,862.44 Dixie ......................... $1,090.29 $1,090.29 $1,090.29 In his deficiency notice to Fitzgerald the Commissioner informed Fitzgerald that it would be entitled to correlative adjustments (deductions) for each of its taxable years ending July 31, 1966-68, if it were finally determined that the income of Loans should be increased for each such taxable year by reason of the advances from Loans to Fitzgerald. The Commissioner advised Fitzgerald to file an appropriate claim, and Fitzgerald has accordingly filed a protective claim for refund (Treasury Form 843) for each of the taxable years.

Petitioners' principal argument is that the imputation of interest income to them to reflect arm's-length charges on the advances they made to their affiliates was beyond the scope of the Commissioner's power under section 482 of the 1954 code. They have not contended that interest was in fact charged upon the advances in question at arm's-length rates, nor have they questioned the Commissioner's use of a 5-percent interest rate or his determination of the average monthly balances of outstanding loans and the amounts of interest income reported by Fitzgerald. We hold that the Commissioner's determinations were authorized by the statute.

With the recent decision of the Court of Appeals in B. Forman Co. v. Commissioner, 453 F.2d 1144 (C.A. 2) reversing in this connection 54 T.C. 912, certiorari denied 407 U.S. 934, rehearing denied 409 U.S. 899, a divergence of views has developed on the issue of whether the Commissioner may use section 482 to impute income to an organization transferring goods to, or performing services for, a related party at less than an arm's-length charge where the controlled group realized no gross income through dealings with third parties as a consequence of the use or consumption of the goods or services by the transferee organization. The Court of Appeals in Forman sustained the Government's position, 453 F.2d at 1155-1156, whereas cases decided prior to Forman, which are relied upon by petitioners herein, had held that section 482 could not thus be used to "create" hypothetical income. Tennessee-Arkansas Gravel Co. v. Commissioner, 112 F.2d 508 (C.A. 6), reversing a Memorandum Opinion of the Board of Tax Appeals; Huber Homes, Inc., 55 T.C. 598; PPG Industries, Inc., 55 T.C. 928, 1007-1010; Texsun Supply Corporation, 17 T.C. 433, 443-445, acq. 1952-1 C.B. 4; Smith-Bridgman Co., 16 T.C. 287, 293-294, acq. 1951-1 C.B. 3;^fn4 E. C. Laster, 43 B.T.A. 159, 176-177, acq. 1941-1 C.B. 7, modified on other issues 128 F.2d 4 (C.A. 5).

Kahler Corp., 58 T.C. 496, nonacq. 1972-2 C.B. 3, and Kerry Investment Co., 58 T.C. 479, nonacq. 1972-2 C.B. 3 — both of which cases, like the one now before us, involved loans upon which less than an arm's-length rate of interest was charged — presented this Court with the opportunity to reexamine its position on the "creation of income" problem under section 482 in light of the decision of the Court of Appeals in Forman. In those decisions, we announced our disagreement with the broad result reached by the Second Circuit and adhered to our prior view that section 482 does not authorize the Commissioner to "create" hypothetical income. However, taking note of the dictum in Huber Homes, Inc., 55 T.C. 598, 610, that "if, as a consequence of * * * use or consumption by the transferee [of goods transferred, or services performed, at less than an arm's-length charge], income is realized within the controlled group, an entirely different question would be presented as to whether such income or a portion thereof might be allocated to the transferor," we held further, in Kerry, that income in fact earned by the debtor corporation with the proceeds of certain of the loans involved therein was properly allocable to the creditor. 58 T.C. at 485-488, 491. Of particular consequence in the present case is the additional rule, established by Kerry, that the taxpayer seeking to avoid the impact of an adverse determination by the Commissioner has the burden of proving that the proceeds of each particular loan were not used by the borrower to produce gross income in the taxable year. 58 T.C. at 489-490.

It is thus clear under our recent decisions that gross income earned by a debtor corporation may be allocated to the creditor, in accordance with a determination by the Commissioner, to the extent that the creditor fails to establish that such income was not earned with the proceeds of funds lent at less than an arm's-length rate. Moreover, so long as the Commissioner proceeds under the theory that gross income is to be allocated — rather than under the theory that interest income may be imputed "without regard to whether the * * * borrowed funds produced income," cf. Kahler Corp., 58 T.C. at 512 — such allocation is permissible even if the Commissioner chooses to cast the appropriate amount of allocable gross income in terms of an arm's-length "interest" charge. See Kerry Investment Co., 58 T.C. at 493; but see PPG Industries, Inc., 55 T.C. 928, 1009.

In the case now before us, the Commissioner has advanced alternative theories in support of his determinations. He has renewed his argument that he is empowered by section 482 to impute interest income to petitioners irrespective of the uses to which the borrowed funds were put by their affiliates. To sustain him on that ground would be at odds with our longstanding position on section 482 which we have so recently reaffirmed, and we decline to do so. The Commissioner has also argued, however, that each of the debtor corporations had gross income in each of the taxable years in issue in amounts far greater than the amounts of income which he has determined should be allocated to petitioners, and that petitioners, who had the burden of proof, have introduced no evidence tending to establish that at least the requisite portions of such gross income were not earned with the proceeds of the loans in issue. Pursuant to our holding in Kerry, we hold that this alternative argument by the Commissioner must prevail.

We reject petitioners' argument that at most only a comparatively minimal amount of gross income earned by the debtor corporations during the taxable years is traceable to advances made during those years, that the major portions of the receivable balances for the years in issue were created by loans made in prior years, and that, relying upon PPG Industries, Inc., 55 T.C. 928, 1009-1010, such prior year loans (even though outstanding during the taxable years) could not be regarded as the source of any income realized during the taxable years. Irrespective of the times at which various loans were made, the debtor corporations had full use in each taxable year of all of the borrowed funds which had not been repaid (or of the assets into which such funds had been converted), and it was incumbent upon petitioners to establish that such funds (or assets) did not generate gross income in each of the taxable years. Nothing in the stipulated materials permits such "tracing" to be undertaken, and petitioners have thus failed to carry their burden of proof. In the Kerry case itself, the proceeds of certain loans which had been outstanding as long (over 17 years) as any of those involved here, and nearly as long as those involved in PPG (about 20 years), were not traced and were therefore deemed to have produced gross income during the years in issue. It is therefore incumbent upon us to follow our more recent decision in Kerry, which was reviewed by the Court, rather than the prior unreviewed decision in PPG.

Decision will be entered for the respondent in docket No. 2135-72.

Decision will be entered under Rule 50 in docket No. 2136-72.