PIERCE

Warren G. Smith and Thomas W. Edwards, III, for the petitioners. John F. Papsidero, for the respondent.

The petitioner borrowed $164,683.61 from a bank for a period of 3 years, under an arrangement whereby the borrower's obligation to repay said principal sum and also its obligation to pay interest thereon of $27,172.99 computed at 5 1/2 percent per annum for the entire 3-year period, were evidenced by a single promissory note for $191,856.60, which was to be paid in 36 equal monthly installments of $5,329.35 each. Held, that the Commissioner did not err in computing the amount of the accrued and deductible interest on said promissory note for a portion of the taxable year involved, by using the ‘straight-line method,‘ rather than by using a ‘sum of the months-digits method’ which petitioner contends should have been used.

PIERCE, Judge:

The Commissioner determined a deficiency of $415.69 in the income tax of the petitioner for its taxable calendar year 1960.

The sole issue for decision is whether the Commissioner erred in determining the amount of interest which petitioner is entitled to accrue and deduct for said year, in respect of a promissory note which it executed and delivered to a local bank in connection with the borrowing of money.

Most of the facts have been established by allegations of fact in the petition, which were admitted by respondent in his answer. No stipulation of facts was filed; although the parties jointly presented the petitioner's income tax return for said year as the sole exhibit. Neither the promissory note involved, nor any accounting record of petitioner was offered or received in evidence. Most of the testimony of the two witnesses related to opinions and discussions regarding accounting methods.

FINDINGS OF FACT

The petitioner, the James Brothers Coal Co., is an Ohio corporation organized in 1914 and having its office at Magnolia, Ohio. Its principal business activity was mining coal and clay. For many years including the present, it kept its books of account and filed its Federal income tax returns in accordance with an accrual method of accounting, and on a calendar year basis. Its income tax return for the taxable year involved was filed with the district director of internal revenue at Cleveland.

On an unidentified date in May 1960, petitioner entered into a transaction with the Peoples Merchant Trust Co. of Canton, Ohio, in which it borrowed the sum of $164,683.61 for a period of 3 years, with interest computed by the bank at 5 1/2 percent per annum for the entire 3-year period in the total amount of $27,172.99. Petitioner's obligations for repayment of said principal and for payment of said total interest, were evidenced by a single promissory note in the amount of $191,856.60 and maturing at the end of 3 years, which petitioner executed and delivered to the bank. The amount of this note for $191,856.60 was to be paid in 36 equal monthly installments of $5,329.35 each, over the 3-year period.

During the taxable year 1960, petitioner made equal monthly payments to the bank in the amounts of $5,329.35 each, as required by the note (each of which payments was equal to 1/36 of $191,856.60, the fact amount of the note).

Also during said year, petitioner ‘charged off’ on its books of account, part of said total 3 years' interest of $27,172.99 which had been included in the total amount of the promissory note.

In making such charge-offs of interest, petitioner used a method which, in the pleadings, testimony, and briefs herein, has sometimes been called ‘the sum of the years-digits method,’ and at other times has been referred to as ‘the sum of the months-digits method.’ The operation of this method was as follows: Petitioner first added all the respective numbers of 1 through 36 (being the numbers of the digits which represented the 36 months included in the 3-year period from the date of execution of the promissory note to the date of the note's maturity), and thereby arrived at a total of 666; it then treated as the interest portion of the first monthly payment of $5,329.35, 36/666 of the total 3 years' interest of $27,172.99; treated as the interest portion of the second monthly payment, 35/666 of said total 3 years' interest; treated as the interest portion of the third monthly payment, 34/666 of said total 3 years' interest; and thereafter similarly decreased the numerator of the fraction by one, in reflecting the interest portion of each respective subsequent monthly payment. The effect of this was to convert the accrual of the interest to a sliding-scale monthly basis, as distinguished from an annual basis; and to adjust accruals of the total agreed interest charge of $27,172.99 from a uniform rate of 5 1/2 percent per annum to larger amounts for the first months (including 7 months of 1960 here involved) than for the later months to be represented by anticipated future payments.

During the taxable year 1960 petitioner had liabilities in addition to those represented by the promissory note here involved— in respect of which interest was paid or accrued. In its income tax return for said year, petitioner claimed a deduction for interest in the total amount of $40,427.57 (which amount exceeds the total 3-year interest obligation included in the promissory note here involved, and as to which no portion can be identified as pertaining to said obligation). Also petitioner's balance sheets as of the beginning and the end of said taxable year (which are attached to its return) show the following items among its liabilities:

+--------------+ ¦¦Beginning ¦¦ +--------------+

of End of taxable year taxable year Line 17. Bonds, notes, and mortgages payable (maturing less than 1 year from date of balance $174,466.66 $176,527.20 sheet) Line 18. Other current liabilities [which per the 40,025.11 33,325.60 attached schedule included accrued interest] Line 20. Bonds, notes, and mortgages payable (maturing 1 year or more from date of balance 433,514.57 353,831.71 sheet)

The Commissioner, in determining the deficiency herein, computed the amount of interest which he allowed as a deduction for the taxable year in respect of the promissory note involved, by using a so-called straight-line method that is hereinafter explained.

OPINION

The issue here, as above stated, is whether the Commissioner erred in determining the amount of interest which the petitioner, an accrual basis taxpayer, is entitled to accrue and deduct for the taxable year in respect of the promissory note involved. Restated more specifically, the question is whether the Commissioner erred in computing the amount of such deductible interest by using the so-called straight-line method— rather than by using the sum of the months-digits method which petitioner used and contends should have been approved by the Commissioner.

1. The basic differences in the applications and effects of these two above-mentioned methods for computing interest deductions, are principally as follows.

The straight-line method which the Commissioner used, operates under the principle that, where a lending institution has loaned money to a borrower for a certain number of years (here 3 years), in consideration of the borrower's promise to pay a specified amount of interest thereon (here $27,172.99 computed at 5 1/2 percent per annum for the 3-year period); and the parties have incorporated in a single promissory note, both the obligation to repay the amount of the loan (here $164,683.61) and also the obligation to pay said total agreed amount of interest; and they have further agreed that the amount of the single note (here $191,856.60) shall be paid in equal monthly installments over the entire period of the note (here in 36 equal monthly installments of $5,329.35 each)— then, in such circumstances and in the absence of proof of any contrary arrangement between the lender and borrower (and here there is no such proof), the interest in respect of the borrower's single promissory note is deemed to accrue ratably over the entire period of said note. Thus in a situation like the present where the period of the note was 3 years (36 months), 1/36 of the total agreed amount of interest (1/36 of $27,172.99) is regarded to be that portion of each monthly payment which represents accrued and deductible interest.

On the other hand, the sum of the months-digits method which petitioner contends should be used, operates under a principle that, notwithstanding the agreement between the lender and borrower, the total amount of the promissory note for 3 years should, in substance and effect, be fragmented into 36 separate monthly obligations, each having a separate monthly maturity— so that each time one of the monthly payments is made, part of the loan obligation is deemed to be retired; and that as these monthly retirements continue from month to month, the amounts of the accrued and deductible interest gradually decrease from a maximum portion of the total $27,172.99 interest (attributed to the first month of the loan) to a minimum portion of said total interest charge (attributed to the last month of the 3-year period). Thus in the instant case, the petitioner disputes the Commissioner's method of uniformly accruing 1/36 of the total agreed interest charge for each month of the 3-year period; and instead, it would accrue 36/666 of the total interest charge in respect of the first month of the promissory note period, 35/666 for the second month, and so on down to 1/666 for the 36th month— thereby creating, as it contends, a larger interest deduction for the first 7 months of the year 1960 here involved, than that which the Commissioner allowed.

2. Section 163 of the 1954 Code provides that: ‘There shall be allowed as a deduction all interest paid or accrued within the taxable year on indebtedness'; but neither this statute nor the regulations thereunder, either fix any particular rate of interest or prescribe any particular method for computing the interest portions of periodic payments made in respect of a single promissory note which covers the obligations of the borrower to pay both the principal and the interest.

However the Internal Revenue Service has, over a period of more than 20 years, had in force income tax rulings which deal, not only with situations (unlike the present) where interest is discounted or paid in full at the time when a loan is made, but also with situations (like the present) where periodic payments covering both principal and interest are to be made over the entire period of the loan. These rulings are: I.T. 3298, 1939-2 C.B. 164. This ruling which deals with both cash basis and accrual basis taxpayers, states in material part as follows:

The M Bank states that it has made a great many FHA loans not exceeding five years, and that the discount or interest on these loans is deductible in advance. Some of the bank's clients have inquired whether the entire amount of the discount or interest should be taken as a deduction in one year, or whether they are required to pro rate it over the life of the notes covering the loan.

The discount or interest paid by the bank's clients with respect to FHA loans should be treated by the borrowers the same as discount or interest paid in connection with other kinds of loans. That is, if the borrower reports his income for Federal income tax purposes on the cash basis, the discount or interest is not actually paid when the money is borrowed and is therefore not deductible by him until the year in which payment of the loan is made. If the borrower reports his income on the accrual basis, the discount or interest should be deducted as it accrues. (Emphasis supplied.)

I.T. 3489, 1941-2 C.B. 71. This ruling which involves facts strikingly similar to those in the instant case is, so far as here material, as follows:

According to the ‘Gross Charge and Discount Tables' issued by the Federal Housing Administration, a person who borrows $100 to be repaid with interest at 5 per cent over a period of three years signs a note in the amount of $114.98 to be paid in 36 equal installments, the excess ($14.98) over the principal amount of the loan representing interest on the principal amount of $100. A person who desires a loan of $100 on the discount basis for a 3-year period receives $86.97 and signs a note for $100 to be paid in 36 equal monthly installments, the difference ($13.03) between the amount received and the face of the note representing (approximately) interest at the rate of 5 per cent per year on the amount received by the borrower.

It is held that when payments are made in accordance with the terms of such notes the aggregate of the interest charged is paid in 36 equal installments. Accordingly, in the case of a loan under either of the plans referred to, one thirty-sixth (1/36) of the total amount representing interest ($14.98 under the gross-charge plan and $13.03 under the discount plan) should be regarded as the portion of each monthly payment which represents interest. (Emphasis supplied.)

The method last-above directed to be used, is the ‘straight-line method’ which the Commissioner applied in the instant case.

Moreover, both this Court and others have long recognized that in the case of an accrual basis taxpayer, interest accrues ratably over the period of the loan. In one of the older cases, Higginbotham-Bailey-Logan Co., 8 B.T.A. 566 (1927), it is stated at page 577:

Interest accrues ratably over the period of the loan and where, as here, the books of the petitioner are kept on a basis other than cash received and disbursed, the law provides that interest is allowable as a deduction as it accrues. The petitioner can not be sustained in its contention that it may deduct interest as it pays it. * * *

To the same effect see J. B. Jemison, 18 B.T.A. 399, 400; Saner-Ragley Lumber Co., 3 B.T.A. 927; and United States Playing Card Co., 15 B.T.A. 975, 981. See also one of the older decisions of the Supreme Court, Story v. Livingston, 13 Pet.359, wherein at page 370 consideration was given to partial payments made on a debt, which cover both principal and interest; and wherein recognition was given the principles that the obligations of the parties should not be varied, and that it is the creditor who should calculate the interest portions of the payments.

3. Petitioner relies for support of its ‘sum of the months-digits method,’ upon section 167 of the 1954 Code which deals with deductions for depreciation; and it points out that there, under regulations prescribed by the Secretary or his delegate, a taxpayer is given an election to compute is reasonable allowance for depreciation by use of a sum of the years-digits method. But petitioner's reliance on said section of the statute is misplaced for each of the following reasons: First, the election to use said method under section 167 is expressly provided by statute; and it is to be applied only in accordance with a specific regulation which points out that the fraction to be applied is one as to which both the numerator and the denominator are fixed on a yearly rather than a monthly basis. Second, said statute and regulation pertain only to depreciation, relating to useful life of property (which can be fixed with reasonable certainty) as distinguished from a liability for a period of years (which may be shortened by subsequent agreement between the lender and borrower, or by prepayments, or by insolvency of the borrower— and which in any of such situations would require a revision of the fraction). And most important of all, section 167(c) of the Code specifically provides that the sum of the years-digits method may be applied thereunder ‘only in the case of property (other than intangible property)’; and also the income tax regulations for said section (sec. 1.167(c)-1) similarly provides that such method is ‘applicable only to tangible property.’ In the instant case, we are not dealing with tangible property.

At the trial herein, each of the petitioner's witnesses expressed an opinion that the sum of the months-digits method was preferable to the straight-line method, and that such method is in accord with ‘generally accepted accounting principles.’ But neither of these witnesses was able upon demand of respondent's counsel, to cite a single accounting authority that has expressly approved the use of such method for computing accrued and deductible interest on a promissory note in a situation like the present.

The petitioner, in the appendix to its reply brief, has referred to sales contracts, stated that ‘one equitable method’ for computing certain provisions of a revised edition of an accounting publication in which the authors, in dealing with interest in respect of installment such interest would be to use a sum of the months-digits method. However, we regard the situation there considered to be distinguishable from the situation here involved.

Neither of petitioner's witnesses expressed any opinion that the straight-line method used by the Commissioner is not a generally accepted method for use in computing accrued and deductible interest, or that its use does not clearly reflect income for income tax purposes.

4. Accounting methods for computing taxable income for Federal income tax purposes are not always the same as those used for commercial accounting purposes. A recent example of such diversity is in the recent case of Schlude v. Commissioner, 372 U.S. 128, wherein the Supreme Court disapproved the taxpayers' method of handling certain receipts for income tax purposes, notwithstanding proffered support for the taxpayers' method which was presented in a brief amicus curiae that was filed on behalf of the American Institute of Certified Public Accountants.

Section 446(b) of the 1954 Code gives the Commissioner, as a delegate of the Secretary of the Treasury, broad discretion to determine in his discretion, whether particular accounting methods clearly reflect income; and the burden of establishing error in his determination is on the petitioner. It is our opinion after considering all the pleadings and all the evidence herein, that the Commissioner, in determining the amount of interest accrued and deductible by petitioner in respect of the promissory note here involved, did not act arbitrarily, capriciously, or unreasonably; and that petitioner has not established error in the Commissioner's determination.

Decision will be entered for the respondent.