Opinion
Docket No. 325-67.
1968-10-21
LINCOLN SAVINGS & LOAN ASSOCIATION, PETITIONER v. COMMISSIONER OF INTERNAL REVENUE, RESPONDENT
Adam Y. Bennion, A. Calder Mackay, and Richard N. Mackay, for the petitioner. James A. Thomas, for the respondent.
Adam Y. Bennion, A. Calder Mackay, and Richard N. Mackay, for the petitioner. James A. Thomas, for the respondent.
Petitioner, a California savings and loan association, insures the accounts of its depositors with the Federal Savings and Loan Insurance Corporation (FSLIC). It pays regular annual premiums for such insurance coverage, which are deductible. Such premiums are part of FSLIC's gross income, available to meet all current expenses and losses, and to the extent not so used are transferred to FSLIC's ‘Primary Reserve’ to meet losses of future years. Since 1962, petitioner has also been required to make additional annual payments ‘in the nature of * * * prepayment(s) with respect to future premiums.’ Such ‘prepayments' immediately become part of the FSLIC's ‘Secondary Reserve,‘ which is available to a limited extent to meet future losses in the event of depletion of all other resources of the FSLIC. Although petitioner has no interest in the Primary Reserve, it has a prorata interest in the Secondary Reserve. That interest is reflected in an account which is rendered to it annually by the FSLIC showing the amount of the ‘prepayments' made by petitioner together with an annual ‘return’ computed upon the balance in the account at the end of each year. The balance in such account is to be used to discharge petitioner's obligation to pay its regular insurance premiums in future years after the total of FSLIC's Primary Reserve and Secondary Reserve reaches a certain level, but petitioner may transfer its account (its prorata interest in the Secondary Reserve) to another insured institution in the event of merger, consolidation or bulk sale, and may recover any unused balance in its account in cash if it terminates insurance with the FSLIC or liquidates. Petitioner's prorata share of the Secondary Reserve appears on its financial statements and the consolidated statements of its parent as an asset, and both State and Federal regulatory agencies require that the ‘prepayments' be capitalized and not expensed until used to pay premiums or cover losses. Held, the ‘prepayments' are also capital expenditures for Federal income tax purposes, deductible only in the years and to the extent used to discharge petitioner's obligation to pay regular insurance premiums or to meet actual losses of the FSLIC.
The Commissioner determined a deficiency in petitioner's income tax of $461,454.38 for the year 1963. Petitioner disputes so much of that deficiency as is based upon the Commissioner's disallowance of a deduction in the amount of $882,626.86, which petitioner claimed as a ‘Federal Insurance Premium’ expense in that year. Petitioner paid this amount to the Federal Savings and Loan Insurance Corporation in 1963, as well as its regular annual insurance premium for that year, as it was required to do by 12 U.S.C.sec. 1727(d), which section characterized the payment as an ‘additional premium in the nature of a prepayment with respect to future premiums.’ The issue for decision is whether such payment was an ordinary and necessary expense of petitioner's business in 1963, or whether it was a capital expenditure deductible, if at all, only when actually used to discharge petitioner's obligation to pay the regular annual insurance premiums or to meet insurance losses of the Federal Savings and Loan Insurance Corporation.
FINDINGS OF FACT
Some of the facts have been stipulated and, as stipulated, are incorporated herein by this reference together with accompanying exhibits.
Lincoln Savings & Loan Association (hereinafter sometimes referred to as petitioner) is a corporation organized under the laws of the State of California, incorporated on February 6, 1925. Its name, originally Lincoln Building & Loan Association, was changed on August 5, 1943, to Lincoln Savings & Loan Association. At the date of the filing of the petition in this case, petitioner's principal office was located at 630 West Sixth Street, Los Angeles, Calif. It filed its tax returns for the calendar years 1962, 1963, and 1964 on the cash receipts and disbursements basis of accounting with the district director of internal revenue, Los Angeles, Calif.
All of petitioner's outstanding stock (consisting of 2,500 shares with a par value of $100 per share) has been owned since 1964 by First Lincoln Financial Corp., which is a corporation organized under the laws of the State of California with its principal office in Los Angeles, Calif. During 1962 and 1963, First Lincoln Financial Corp. owned 98.88 percent of petitioner's outstanding stock. On December 31, 1963, First Lincoln Financial Corp. had 1,402,654 shares of stock outstanding, without par value, owned by approximately 2,800 shareholders. Its stock is traded overthecounter.
Petitioner was licensed as a savings and loan association by the savings and loan commissioner of the State of California on February 6, 1925, and since that date has been and remains a licensed savings and loan association under the laws of the State of California, transacting business in the Los Angeles area. As such, it is regulated by Division II of the California Financial Code (Cal. Fin. Code sec. 5000 et seq. (West)) and by regulations of the California savings and loan commissioner, which law and regulations are incorporated herein by reference.
Petitioner is a member of the Federal Home Loan Bank of San Francisco, 1 of 12 regional district banks established and supervised by the Federal Home Loan Bank Board (hereinafter sometimes referred to as the FHLB Board) under authority of the Federal Home Loan Bank Act of 1932. See 12 U.S.C.sec. 1423. These banks provide additional liquidity and funds for mortgage lending by making advances to member institutions as needed to meet unusual or heavy withdrawal and credit demands. As a condition of membership, each member institution is required to purchase capital stock in its bank equal to 1 percent of its outstanding ‘unpaid loan principal,‘ and to invest in such amounts of stock thereafter as is necessary to maintain this percentage. 12 U.S.C.sec. 1426(c). Prior to 1962 the statutory level was 2 percent but thereafter, as part of a comprehensive legislative plan calling for certain additional payments by ‘insured institutions' to the Federal Savings and Loan Insurance Corporation, as hereinafter set forth, the level was reduced to 1 percent.
Since 1938, petitioner has been an ‘insured institution’ of the Federal Savings and Loan Insurance Corporation (hereinafter sometimes referred to as the FSLIC), a corporation created by the laws of the United States under title IV of the National Housing Act of 1934, 12 U.S.C.sec. 1724 et seq., and operated under the direction of the FHLB Board, which is required by statute to insure the accounts of all Federal savings and loan associations, and is permitted to insure the accounts of qualified State-chartered savings and loan associations, such as petitioner. 12 U.S.C.sec. 1726. Members of the Federal Home Loan Bank system are not required to insure the savings accounts of their depositors with the FSLIC, unless they are also Federally chartered savings and loan associations. Similarly, except for Federal savings and loan associations, any insured institution of the FSLIC may voluntarily terminate such insurance, provided adequate notice is given to depositors and other technical requirements are met; the FHLB Board may, however, direct an involuntary termination of the insurance of any insured institution under certain conditions, though it has done so only once in the history of the FSLIC. Petitioner placed a great deal of emphasis in its advertising upon the fact that it was a Federally insured institution and, in the opinion of its management, loss of its insured status with the FSLIC would cause a mass withdrawal of savings by its depositors.
Prior to January 1, 1962, each insured institution was required by section 1727(a) of title 12 of the United States Code (sec. 404(a) of the National Housing Act) to pay an annual insurance premium to the FSLIC equal to 1/12 of 1 percent of the total amount of its savings accounts and creditor obligations. Such premiums were to be continued until the FSLIC's reserve for losses equaled or exceeded 5 percent of the insured accounts and creditor obligations of all insured institutions (its potential liabilities), and at such intervals thereafter as might be required to keep the reserve fund at this level. Public Law 87-210, 75 Stat. 482, pertinent parts of which are set forth in the margin,
amended section 1727 of title 12 of the United States Code effective January 1, 1962, to its present form. An annual insurance premium at the rate of 1/12 of 1 percent is still required of all insured institutions (provision for which is now made in sec. 1727(b)(1)), though the point at which such premiums are to cease and the level at which the FSLIC's general reserve is to be maintained has been lowered from 5 to 2 percent of total insured savings and creditor obligations of insured institutions. Sec. 1727(b)(2). But an insured institution is now required under the amended provisions of section 1727, to make further annual payments to the FSLIC (provided for in 12 U.S.C.sec. 1727(d) and hereinafter sometimes referred to as section 1727(d) payments) equal to 2 percent of any net increase in the total amount of its insured accounts during the previous year, reduced, however, by an amount equal to any requirement, as of the end of such year, for the purchase of stock in a Federal Home Loan Bank of which the insured institution is a member. Public Law 87-210 also amended section 6 of the Federal Home Loan Bank Act (12 U.S.C.sec. 1426), to reduce the percentage of stock which a member of a Federal Home Loan Bank is required to hold in relation to its outstanding home mortgage loans, with certain exceptions relating to stock already purchased, from 2 to 1 percent. It was contemplated that, for most member institutions, the section 1727(d) ‘prepayment requirement would be approximately offset’ by the resulting reduction in outlays for Federal Home Loan Bank stock which a member institution was theretofore (prior to 1962) required to make. H. Rept. No. 823, 87th Cong., 1st Sess., p. 2.
As of June 30, 1963.
Transferred from the account of another savings and loan association due to merger.
Section 8701 of the California Financial Code authorizes the savings and loan commissioner to establish a uniform classification of accounts for savings and loan associations and to prescribe the manner in which such accounts are to be kept. On May 21, 1962, the California savings and loan commissioner issued an order prescribing the procedure for accounting for section 1727(d) payments, which order was modified and incorporated into the ‘Uniform Classification of Accounts' effective January 1, 1963, and, as modified, has remained effective for all subsequent periods. The ‘Uniform Classification of Accounts' requires each California savings and loan association to treat section 1727(d) payments as an asset, in an account entitled ‘Contributions to Secondary Reserve— FSLIC’; to treat the return credited to its prorata share of the Secondary Reserve as income when notified by the FSLIC that such return has been credited to its account; and to treat transfers made from its prorata share of the Secondary Reserve to discharge its obligation to pay regular annual premiums as expenses when notified of such transfer.
On petitioner's balance sheet for the year 1962, its section 1727(d) payment for that year, and the statutory interest credited thereon, were included in ‘Other Assets'; beginning in 1963, all section 1727(d) payments have been shown, on the asset side of the balance sheet, as ‘Prepaid Federal Savings and Loan Insurance Corporation Premiums.’ Such payments were not included as an expense on any of its income statements for the periods 1962 through 1966. The interest credited to petitioner's account pursuant to section 1727(e) by the FSLIC for each of the years 1962 through 1966 was included in miscellaneous income for the year in which the interest was credited to petitioner's account by the FSLIC. These items were similarly treated on the consolidated financial statements of petitioner's parent, First Lincoln Financial Corp., and its subsidiaries. All of petitioner's financial statements for the years 1962 through 1966, and all consolidated financial statements of its parent for those years, were audited by the firm of Peat, Marwick, Mitchell & Co., certified public accountants, which submitted accompanying ‘Accountant's Reports' stating that the financial position of petitioner (or its parent) had been presented fairly therein, ‘in conformity with generally accepted accounting principles applied on a basis consistent with that of the preceding year.’
The regulations of the FHLB Board require each savings and loan association which is a member of the Federal Home Loan Bank system to file, on forms provided by the Board, a semiannual report of its affairs as of the end of each semiannual period. Printed instructions for the preparation of such reports are published and distributed to each member. The ‘Introduction’ to these instructions states that: ‘These instructions are provided to assist in the completion of monthly and semiannual reports by members of the Federal Home Loan Bank System. Each reporting institution is urged to carefully follow these instructions * * * .’ Under the heading ‘Schedule D, Other Assets,‘ each institution insured by the FSLIC is instructed to report in that category ‘the amount of its prorata share in the Secondary Reserve established by the Corporation from the premium prepayments.’ In all of its reports to the FHLB since 1962 petitioner has reported its prorata share of the Secondary Reserve as an asset under the heading ‘Other Assets,‘ as required by such instructions.
On its Federal income tax return for the years 1962, 1963, and 1964, petitioner deducted both its section 1727(b)(1) regular premium payments and its section 1727(d) payments under ‘other deductions' as ‘Federal insurance premiums.’ Upon examination of its returns for those years, the Commissioner allowed the deduction for amounts paid under section 1727(b)(1), but disallowed a deduction for all section 1727(d) payments. In its petition to this Court, petitioner put in issue the greater part of the deficiency in its income tax as determined by the Commissioner with respect to the calendar year 1963.
It concedes the correctness of all the adjustments made by the Commissioner for 1963 with the exception of his disallowance of a deduction of $882,636.86, the amount of the section 1727(d) payment made by petitioner in that year.
There was no deficiency in petitioner's income tax in the other years.
Decision will be entered for the respondent. Public Law 87-210 amended sec. 404 of the National Housing Act (12 U.S.C.sec. 1727) to read as follows:SEC. 1727. Primary and secondary reserves.(a) Establishment.The Corporation shall establish a Primary Reserve which shall be the general reserve of the Corporation and a Secondary Reserve to which shall be credited the amounts of the prepayments made by insured institutions pursuant to subsection (d) of this section and the credits made pursuant to the first sentence of subsection (e) of this section.(b) Premiums for insurance; amount; time of payment; waiver, rules and regulations.(1) Each institution whose application for insurance is approved by the Corporation shall pay to the Corporation, in such manner as it shall prescribe, a premium for such insurance equal to one-twelfth of 1 per centum of the total amount of all accounts of the insured members of such institution plus any creditor obligations of such institution. Such premium shall be paid at the time the certificate is issued by the Corporation under section 1726 of this title, and thereafter annually, except that under regulations prescribed by the Corporation such premium may be paid semiannually.(2) If, at the close of any December 31, the Primary Reserve equals or exceeds 2 per centum of the total amount of all accounts of insured members and creditor obligations of all insured institutions as of such close, no premium under paragraph (1) of this subsection shall be payable by any insured institution with respect to its premium year beginning during the year commencing on May 1 next succeeding such December 31, except that the foregoing provisions of this sentence shall not be applicable to any insured institution with respect to any of the twenty premium years beginning with the premium year commencing with the date on which such certificate is issued.(3) The Corporation is authorized to prescribe such rules and regulations as it may determine to be necessary or appropriate to accomplish the purposes and provisions of this subsection.(d) Prepayments; amount; credit to Secondary Reserve; amount for newly insured institutions.Each insured institution, except as otherwise provided in this section, shall annually pay to the Corporation, at such time and in such manner as the Corporation shall by regulations or otherwise prescribe, an additional premium in the nature of a prepayment with respect to future premiums of such institution under subsection (b) of this section equal to 2 per centum of the net increase in all accounts of its insured members during the next preceding calendar year, less an amount equal to any requirement, as of the end of such calendar year, for the purchase of stock of the Federal Home Loan Bank of which such institution is a member, calculated in accordance with the provisions of subsection (c) of section 1426 of this title and without regard to any net increase during such calendar year in its holdings of such stock, and such prepayments shall be credited to the Secondary Reserve * * *(e) Credits to Secondary Reserve; availability for losses; assignment or transfer of share of Reserve.The Corporation, in accordance with such regulations as it may prescribe, shall credit to the Secondary Reserve, as of the close of each calendar year a return on the outstanding balances of the Secondary Reserve during such calendar year, as determined by the Corporation, at a rate equal to the average annual rate of return to the Corporation during the year ending at the close of November 30 of such calendar year, as determined by the Corporation, on the investments held by the Corporation in obligations of, or guaranteed as to principal and interest by, the United States. Except as provided in subsections (f) and (g) of this section, the Secondary Reserve shall be available to the Corporation only for losses of the Corporation and shall be so available only to such extent as other accounts of the Corporation which are available therefor are insufficient for such losses. No right, title, or interest of any institution in or with respect to its pro rata share of the Secondary Reserve shall be assignable or transferable, whether by operation of law or otherwise, except to such extent as the Corporation may by regulation or otherwise provide for transfer of such pro rata share in cases of merger or consolidation transfer of bulk assets as defined by the Corporation by regulation or otherwise for the purposes of this sentence, and similar transactions as so defined.(f) Cessation of prepayments; distribution of share of Secondary Reserve; reinstatement of reserve share; payment; waiver, or other treat of accruals.If (i) the status of an insured institution as an insured institution is terminated pursuant to any provision of section 1730 of this title or the insurance of accounts of an insured institution is otherwise terminated, (ii) a conservator, receiver, or other legal custodian is appointed for an insured institution under the circumstances and for the purpose set forth in subsection (d) of section 1724 of this title, or (iii) the Corporation makes a determination that for the purposes of this subsection an insured institution has gone into liquidation, the obligation of such institution to make prepayments under subsection (d) of this section, including any prepayments as to which such institution is obligated at the time of such termination, appointment, or determination, shall cease, and the Corporation shall pay in cash to such institution its pro rata share of the Secondary Reserve, in accordance with such terms and conditions as the Corporation may prescribe by regulations or otherwise, or, at the option of the Corporation, the Corporation may apply the whole or any part of the amount which would otherwise be paid in cash toward the payment of any indebtedness or obligation, whether matured or not, of such institution to the Corporation, then existing or arising before such payment in cash * * *(g) Suspension of prepayments, resumption of obligation upon insufficiency of aggregate reserves; cash distribution of shares of Secondary Reserve.If, at the close of any December 31, the aggregate of the Primary Reserve and the Secondary Reserve equals or exceeds 2 per centum of the total amount of all accounts of insured members and creditor obligations of all insured institutions but the Primary Reserve does not equal or exceed such 2 per centum, no insured institution shall be obligated to make any prepayment under subsection (d) of this section during the year beginning with May 1 next succeeding such close, and such insured institution's pro rata share of the Secondary Reserve shall be used to the extent available, to discharge such institution's obligation for its premium under subsection (b) of this section for the premium year beginning in such year; and the suspension of obligation to make such prepayments and the use of such pro rata shares as provided in this sentence shall continue unless and until the next sentence or the last sentence of this subsection shall become operative. If, at the close of any December 31 occurring before the last sentence of this subsection shall become operative, the aggregate of the Primary Reserve and the Secondary Reserve is not at least equal to 1 3/4 per centum of the total amount of all accounts of insured members and creditor obligations of all insured institutions (i) the obligation of insured institutions to make prepayments under subsection (d) of this section shall resume on May 1 next following such December 31 and shall continue unless and until the first sentence or the last sentence of this subsection shall become operative, and (ii) the use of any insured institution's pro rata share of the Secondary Reserve under the first sentence of this subsection shall terminate with respect to its premium under subsection (b) of this section for the premium year beginning during the calendar year commencing on May 1 next succeeding such December 31, and such termination shall continue unless and until the first sentence of this subsection shall become operative. If, at the close of any December 31, the Primary Reserve equals or exceeds such 2 per centum, the Corporation shall, at such time (which shall be the same for all insured institutions and shall not be later than May 1 next succeeding such close) and in such manner as the Corporation shall determine, pay in cash to each insured institution its pro rata share of the Secondary Reserve and shall not, after such time, accept or receive further prepayments under subsection (d) of this section.Public Law 87-210 also amended sec. 6 of the Federal Home Loan Bank Act (12 U.S.C.sec. 1426) to read as follows:SEC. 1426. Capital stock.(c) Minimum subscriptions; retirement of oversubscriptions; limitations; cancellation of oversubscriptions; aggregate unpaid loan principal; reports and information.(1) The original stock subscription of each institution eligible to become a member under section 1424 of this title shall be an amount equal to 1 per centum of the subscriber's aggregate unpaid loan principal, but not less than $500. The bank shall annually, as of the close of the calendar year, adjust, at such time and in such manner and upon such terms and conditions as the Federal Home Loan Bank Board may by regulations or otherwise prescribe, the amount of stock held by each member so that such member shall have invested in the stock of the Federal Home Loan Bank at least an amount calculated in the manner provided in the next preceding sentence (but not less than $500). If the bank finds that the investment of any member in stock is greater than that required under this subsection it may, unless prohibited by said Board or by the provisions of paragraph (2) of this subsection, in its discretion and upon application of such member retire the stock of such member in excess of the amount so required. Said Board, in its discretion, may, by regulations or otherwise, provide for adjustments in amounts of stock to be issued or retired in order that stock may be issued or retired only in entire shares. 2. The FSLIC, during the 27 years of its existence prior to June 30, 1961, had incurred net insurance losses of only $5.1 million, approximately 1.1 percent of its cumulative gross income.
Under the terms of section 1727, as amended by Public Law 87-210, the FSLIC is directed to establish a ‘Primary Reserve,‘ and a ‘Secondary Reserve.’ Sec. 1727(a). The Primary Reserve is credited annually with the net income of the FSLIC, and thus represents its ‘retained earnings.’ Regular insurance premiums paid by insured institutions under section 1727(b)(1) constitute one of the major items of the FSLIC's gross income, and, to the extent that such premiums exceed expenses and insurance losses in any given year, they are thus transferred as part of the FSLIC's net income to the Primary Reserve. Section 1727(d) payments, on the other hand, though described in the statute as ‘additional premium(s) in the nature of * * * prepayment(s) with respect to future premiums,‘ are not regarded as an item of income by the FSLIC, which is required by section 1727(a) to credit all such payments directly to the ‘Secondary Reserve.’ The FSLIC is also required to credit the ‘Secondary Reserve’ with an annual ‘return’ on the outstanding balances in that account at the end of each year, computed ‘at a rate equal to the average annual rate of return to the Corporation * * * on the investments held by the Corporation in obligations of, or guaranteed as to principal and interest by, the United States.’ Sec. 1727(e). Finally, whereas the ‘Primary Reserve’ is ‘the general reserve of the Corporation (i.e., the FSLIC), ‘ the ‘Secondary Reserve’ is available ‘only for losses of the Corporation and shall be so available only to such extent as other accounts of the Corporation which are available therefor are insufficient for such losses.’ Sec. 1727(e).
Each insured institution maintains an interest in a prorata share of the ‘Secondary Reserve,‘ and though its ‘right, title or interest’ therein is not generally transferable or assignable, the FSLIC has authority to provide for the transfer of such prorata share ‘in cases of merger or consolidation transfer of bulk assets * * * and similar transactions.’ Sec. 1727(e). Moreover, an insured institution is entitled to a cash refund of its prorata share in the event that (1) its status as an insured institution is terminated, or (2) a conservator, receiver, or other legal custodian is appointed for the purpose of liquidating the assets of the institution, or (3) the FSLIC determines that such institution has gone into voluntary liquidation. Sec. 1727(f).
When, at the close of any December 31, the aggregate of the Primary Reserve and the Secondary Reserve equals or exceeds 2 percent of the total amount of all insured accounts and creditor obligations of all insured institutions, the obligation of insured institutions to make section 1727(d) payments will be suspended for the following year and all succeeding years; the obligation to make section 1727(d) payments is to resume in the year following any December 31 on which such aggregate amount falls below 1 3/4 percent of all insured accounts and creditor obligations, and is to terminate permanently when the amount in the Primary Reserve alone equals or exceeds 2 percent of such accounts and obligations. In any year in which the obligation to make section 1727(d) payments is suspended, as described above, the prorata share of each insured institution in the Secondary Reserve will be used, to the extent available, to discharge its obligation to pay the regular insurance premium for that year. After the Primary Reserve alone reaches the 2-percent level, each insured institution is entitled to the return of its prorata share of the Secondary Reserve, if any, in cash. Sec. 1727(g).
A schedule appearing shortly hereinafter sets forth estimates of the reserve position of the FSLIC in terms of the expected ratio of the Primary Reserve, the Secondary Reserve, and the aggregate of the Primary and Secondary Reserves to the total of all accounts and creditor obligations of all insured institutions for the years 1962-95. These estimates, prepared in the Office of the Comptroller of the FSLIC and submitted to the Senate Committee on Banking and Currency in connection with that committee's consideration of the bill which became Public Law 87-210, were based upon certain assumptions, viz:
1. No insurance losses.
2. Premium income computed on annual billing basis of one-twelfth of 1 percent.
3. Investment income based on annual average rate of return of 3 percent.
4. Operating expenses based on current rate of expenditure equal to 3.7 percent of premium income.
5. Mortgage loans held estimated at 96 percent of total savings capital.
6. Net home mortgages estimated at 90 percent of mortgage loans held.
7. Annual growth in savings of $7 billion plus dividends at an annual rate of 3 percent.
In addition to the foregoing estimates, the schedule also shows the actual percentage of the aggregate of the Primary and Secondary Reserves to the total amount of all accounts and creditor obligations of insured institutions during the years 1963-67, as shown on the financial statements of the FSLIC for those years. The schedule described above is as follows:
+---------------------------------------------------+ ¦ ¦Primary ¦Secondary¦Aggregate of Primary ¦ +--------+---------+---------+----------------------¦ ¦ ¦Reserve ¦Reserve ¦and Secondary Reserves¦ +--------+---------+---------+----------------------¦ ¦Dec. 31—¦ ¦ ¦ ¦ +--------+---------+---------+----------------------¦ ¦ ¦Estimated¦Estimated¦Estimated ¦Actual ¦ +--------+---------+---------+------------+---------¦ ¦ ¦ratio ¦ratio ¦ratio ¦ratio ¦ +--------+---------+---------+------------+---------¦ ¦1962 ¦0.642 ¦0.227 ¦0.869 ¦ ¦ +--------+---------+---------+------------+---------¦ ¦1963 ¦0.661 ¦0.417 ¦1.078 ¦1 1.04 ¦ +--------+---------+---------+------------+---------¦ ¦1964 ¦0.685 ¦0.581 ¦1.266 ¦1.20 ¦ +--------+---------+---------+------------+---------¦ ¦1965 ¦0.712 ¦0.723 ¦1.435 ¦1.35 ¦ +--------+---------+---------+------------+---------¦ ¦1966 ¦0.741 ¦0.849 ¦1.590 ¦1.53 ¦ +--------+---------+---------+------------+---------¦ ¦1967 ¦0.773 ¦0.963 ¦1.736 ¦1.62 ¦ +--------+---------+---------+------------+---------¦ ¦1968 ¦0.807 ¦1.067 ¦1.874 ¦ ¦ +--------+---------+---------+------------+---------¦ ¦1969 ¦0.842 ¦1.148 ¦1.990 ¦ ¦ +--------+---------+---------+------------+---------¦ ¦1970 ¦0.879 ¦1.177 ¦2.056 ¦ ¦ +--------+---------+---------+------------+---------¦ ¦1971 ¦0.917 ¦1.052 ¦1.969 ¦ ¦ +--------+---------+---------+------------+---------¦ ¦1972 ¦0.956 ¦0.935 ¦1.891 ¦ ¦ +--------+---------+---------+------------+---------¦ ¦1973 ¦0.996 ¦0.825 ¦1.821 ¦ ¦ +--------+---------+---------+------------+---------¦ ¦1974 ¦1.036 ¦0.720 ¦1.757 ¦ ¦ +--------+---------+---------+------------+---------¦ ¦1975 ¦1.078 ¦0.620 ¦1.699 ¦ ¦ +--------+---------+---------+------------+---------¦ ¦1976 ¦1.121 ¦0.667 ¦1.787 ¦ ¦ +--------+---------+---------+------------+---------¦ ¦1977 ¦1.164 ¦0.710 ¦1.874 ¦ ¦ +--------+---------+---------+------------+---------¦ ¦1978 ¦1.208 ¦0.752 ¦1.960 ¦ ¦ +--------+---------+---------+------------+---------¦ ¦1979 ¦1.252 ¦0.792 ¦2.045 ¦ ¦ +--------+---------+---------+------------+---------¦ ¦1980 ¦1.298 ¦0.696 ¦1.994 ¦ ¦ +--------+---------+---------+------------+---------¦ ¦1981 ¦1.343 ¦0.603 ¦1.946 ¦ ¦ +--------+---------+---------+------------+---------¦ ¦1982 ¦1.390 ¦0.512 ¦1.902 ¦ ¦ +--------+---------+---------+------------+---------¦ ¦1983 ¦1.437 ¦0.424 ¦1.860 ¦ ¦ +--------+---------+---------+------------+---------¦ ¦1984 ¦1.484 ¦0.338 ¦1.822 ¦ ¦ +--------+---------+---------+------------+---------¦ ¦1985 ¦1.532 ¦0.253 ¦1.785 ¦ ¦ +--------+---------+---------+------------+---------¦ ¦1986 ¦1.580 ¦0.171 ¦1.751 ¦ ¦ +--------+---------+---------+------------+---------¦ ¦1987 ¦1.629 ¦0.218 ¦1.848 ¦ ¦ +--------+---------+---------+------------+---------¦ ¦1988 ¦1.679 ¦0.264 ¦1.943 ¦ ¦ +--------+---------+---------+------------+---------¦ ¦1989 ¦1.729 ¦0.309 ¦2.038 ¦ ¦ +--------+---------+---------+------------+---------¦ ¦1990 ¦1.779 ¦0.226 ¦2.005 ¦ ¦ +--------+---------+---------+------------+---------¦ ¦1991 ¦1.830 ¦0.145 ¦1.975 ¦ ¦ +--------+---------+---------+------------+---------¦ ¦1992 ¦1.881 ¦0.074 ¦1.955 ¦ ¦ +--------+---------+---------+------------+---------¦ ¦1993 ¦1.932 ¦ ¦1.932 ¦ ¦ +--------+---------+---------+------------+---------¦ ¦1994 ¦1.984 ¦ ¦1.984 ¦ ¦ +--------+---------+---------+------------+---------¦ ¦1995 ¦2.037 ¦ ¦2.037 ¦ ¦ +---------------------------------------------------+
In summary, according to the FSLIC projections in 1961, the aggregate of the Primary Reserve and the Secondary Reserve would equal or exceed 2 percent of all insured accounts and creditor obligations of all insured institutions by 1970, and all section 1727(d) payments, together with all amounts credited thereon, would be consumed in discharging the obligation of insured institutions to pay regular insurance premiums by the time that the Primary Reserve itself reaches the 2-percent level in 1995.
During the years 1962 through 1967, petitioner received annual ‘Insurance Premium Notices' from the FSLIC charging it with ‘Annual Premium(s) at rate of 1/12 of 1%’ (of its insured accounts and creditor obligations) in the following amounts:
+------------------------------------+ ¦Year ¦Premiums ¦Year ¦Premiums ¦ +------+----------+------+-----------¦ ¦1962 ¦$93,258.58¦1965 ¦$271,477.00¦ +------+----------+------+-----------¦ ¦1963 ¦135,760.52¦1966 ¦317,427.60 ¦ +------+----------+------+-----------¦ ¦1964 ¦196,413.86¦1967 ¦373,025.38 ¦ +------------------------------------+
All such sums were paid by petitioner to the FSLIC in the year assessed.
During each of those same years, petitioner also received from the FSLIC a separate ‘Notice of Insurance Premium Prepayment,‘ which set forth the amounts due from petitioner, and the manner in which computed, generally as follows:
+------------------------------------------------------------+ ¦ ¦Increase in ¦ ¦ ¦ ¦ +----+---------------+-------------+------------+------------¦ ¦ ¦accounts of ¦Gross ¦ ¦ ¦ +----+---------------+-------------+------------+------------¦ ¦ ¦petitioner's ¦prepayment ¦FHL Bank ¦Net amount ¦ +----+---------------+-------------+------------+------------¦ ¦Year¦insured members¦(2 percent of¦stock credit¦due June 1 ¦ +----+---------------+-------------+------------+------------¦ ¦ ¦(depositors) ¦increase in ¦ ¦ ¦ +----+---------------+-------------+------------+------------¦ ¦ ¦during ¦prior year) ¦ ¦ ¦ +----+---------------+-------------+------------+------------¦ ¦ ¦preceding year ¦ ¦ ¦ ¦ +----+---------------+-------------+------------+------------¦ ¦1962¦$6,337,974 ¦$126,759.48 ¦0 ¦$126,759.48 ¦ +----+---------------+-------------+------------+------------¦ ¦1963¦44,131,843 ¦882,636.86 ¦0 ¦882,636.86 ¦ +----+---------------+-------------+------------+------------¦ ¦1964¦61,746,484 ¦1,234,929.68 ¦784,100 ¦450,829.68 ¦ +----+---------------+-------------+------------+------------¦ ¦1965¦71,489,450 ¦1,429,789.00 ¦334,700 ¦1,095,089.00¦ +----+---------------+-------------+------------+------------¦ ¦1966¦61,303,238 ¦1,226,064.76 ¦0 ¦1,226,064.76¦ +----+---------------+-------------+------------+------------¦ ¦1967¦(1,944,138) ¦0 ¦0 ¦0 ¦ +------------------------------------------------------------+
All such section 1727(d) payments billed to petitioner were paid by it to the FSLIC in the year due.
All section 1727(d) payments have been credited on the books and records of the FSLIC directly to its ‘Secondary Reserve.’ Effective with the first of such payments, the FSLIC has maintained separate accounts for each insured institution and annually forwards statements to such institutions showing, among other things, the total amount of section 1727(d) payments made to that time, the interest credited annually by the FSLIC to the account pursuant to section 1727(e), and the insured institution's prorata share of the Secondary Reserve. Petitioner's account, No. 2066, reflects the following:
+-----------------------------------------------------------------------------+ ¦ ¦Sec. 1727(d)¦Annual return ¦Prorata share of Secondary ¦ ¦ ¦ ¦ ¦Reserve ¦ +------+------------+-----------------------+---------------------------------¦ ¦Date ¦Payment ¦ ¦ ¦ +------+------------+-----------------------+---------------------------------¦ ¦ ¦ ¦Rate ¦Amount ¦Debit¦Credit ¦Balance ¦ +------+------------+-----------------------+-----+--------------+------------¦ ¦5/31/ ¦$126,759.48 ¦ ¦ ¦$126,759.48 ¦$126,759.48 ¦ ¦62 ¦ ¦ ¦ ¦ ¦ ¦ +-------------------+-----------------------+-----+--------------+------------¦ ¦12/31/62 ¦3.151433% ¦$2,342.10 ¦ ¦2,342.10 ¦129,101.58 ¦ +-------------------+-----------------------+-----+--------------+------------¦ ¦5/31/ ¦882,636.86 ¦ ¦ ¦882,636.86 ¦1,011,738.44¦ ¦63 ¦ ¦ ¦ ¦ ¦ ¦ +-------------------+-----------------------+-----+--------------+------------¦ ¦12/31/63 ¦3.549594% ¦22,951.42 ¦ ¦22,951.42 ¦1,034,689.86¦ +-------------------+-----------------------+-----+--------------+------------¦ ¦5/28/ ¦450,829.68 ¦ ¦ ¦450,829.68 ¦1,485,519.54¦ ¦64 ¦ ¦ ¦ ¦ ¦ ¦ +-------------------+-----------------------+-----+--------------+------------¦ ¦12/31/64 ¦Not in ¦44,864.25 ¦ ¦44,864.25 ¦1,530,383.79¦ ¦ ¦record ¦ ¦ ¦ ¦ ¦ +-------------------+-----------------------+-----+--------------+------------¦ ¦6/1/65¦1,095,089.00¦ ¦ ¦1,095,089.00 ¦2,625,472.79¦ +-------------------+-----------------------+-----+--------------+------------¦ ¦12/31/65 ¦3.555086% ¦77,231.97 ¦ ¦77,231.97 ¦2,702,704.76¦ +-------------------+-----------------------+-----+--------------+------------¦ ¦6/1/66¦1,226,064.76¦ ¦ ¦1,226,064.76 ¦3,928,769.52¦ +-------------------+-----------------------+-----+--------------+------------¦ ¦12/31/66 ¦3.837323% ¦131,295.86¦ ¦131,295.86 ¦4,060,065.38¦ +-------------------+------------+----------+-----+--------------+------------¦ ¦6/1/67¦0 ¦ ¦ ¦ ¦0 ¦4,060,065.38¦ +-------------------+------------+----------+-----+--------------+------------¦ ¦12/31/67 ¦4,232271% ¦171,832.97¦ ¦171,832.97 ¦4,231,898.35¦ +-------------------------------------------+-----+--------------+------------¦ ¦12/31/67 ¦ ¦1 690,217.11¦4,922,115.46¦ +-----------------------------------------------------------------------------+
OPINION
RAUM, Judge:
Petitioner, a savings and loan association licensed by the State of California and doing business in the Los Angeles area, has since 1938 insured the savings accounts of its depositors with the Federal Savings and Loan Insurance Corporation (the ‘FSLIC’), pursuant to the provisions of title IV of the National Housing Act, as amended. (12 U.S.C.sec. 1724 et seq.) It pays an annual ‘premium for such insurance’ in an amount equal to 1/12 of 1 percent of the total amount of all its savings accounts and creditor obligations, as provided in section 1727(b)(1). Since 1962, as the result of amendments made to the National Housing Act, petitioner has been required to make further annual payments to the FSLIC under section 1727(d), hereinafter sometimes referred to as ‘section 1727(d) payments,‘ equal to 2 percent of any net increase in its insured accounts during the previous year, but reduced in the case of an insured institution, such as petitioner, which is also a member of a Federal home loan bank, by the amount of any required purchase of stock in such Bank for that year. These section 1727(d) payments are described in the statute as ‘additional premium(s) in the nature of * * * prepayment(s) with respect to future premiums.’ In 1963, the only year here in issue, petitioner paid its annual insurance premium for the year in the amount of $135,760.52, and made its section 1727(d) payment in the amount of $882,636.86. Both sums were deducted on its 1963 Federal income tax return as ‘Federal insurance premiums.’ The Commissioner, while not disputing petitioner's right to deduct its regular annual insurance premium, disallowed in full the deduction of $882,636.86 claimed for the additional section 1727(d) payment. The sole issue for decision is whether this latter payment was an ordinary and necessary expense of petitioner's business in 1963, or a capital expenditure deductible, if at all, only in later years to the extent that it ceased to be an asset of petitioner.
Although described in the statute as ‘an additional premium in the nature of a prepayment with respect to future premiums,‘ the section 1727(d) payment is neither an ‘additional premium,‘ in the sense of being a mere increase in the annual insurance premium as contended by petitioner, nor a ‘prepayment with respect to future premiums,‘ at least insofar as the ordinary prepaid insurance premium is taken as a standard. The National Housing Act is not, of course, a revenue statute, and the label attached to section 1727(d) payments therein is not, and was not intended to be, conclusive in the determination of how these payments should be treated for Federal tax purposes. See McMillan Mortgage Co., 36 T.C. 924, 928. The label is at any rate ambiguous, though if we were to give it binding effect here, we should most certainly adopt the characterization of ‘prepayment’ as controlling, and would therefore have to deny petitioner a current deduction for its section 1727(d) payment under a long line of decisions by this Court holding that prepaid insurance premiums are capital expenditures to be expensed over the years in which coverage is actually obtained. Higginbotham-Bailey-Logan Co., 8 B.T.A. 566, 577; George S. Jephson, 37 B.T.A. 1117, 1119-1120; Martha R. Peters, 4 T.C. 1236, 1242; Louise K. Herter, 20 T.C.M. 78, 86, 30 P-H.Memo.T.C.par. 61,019. See and compare Commissioner v. Boylston Market Assn., 131 F.2d 966 (C.A. 1), affirming a Memorandum Opinion of the Board of Tax Appeals, with Waldheim Realty & Inv. Co. v. Commissioner, 245 F.2d 823 (C.A. 8), reversing 25 T.C. 1216. But regardless of whether the section 1727(d) payment may properly be characterized as a prepaid insurance premium, we reach the same ultimate result, for an analysis of the substantive provisions of section 1727 convinces us that this payment, however labeled, is in the nature of a capital outlay and is therefore not deductible as an expense in the year that it is made.
That the section 1727(d) payment is qualitatively different from the regular annual insurance premium payable under section 1727(b)(1), and constitutes something more than a mere increase in the premium rate, seems to us beyond question. Regular annual premiums are part of the gross income of the FSLIC and, along with its income from investments, are used to meet the FSLIC's operating expenses and insurance losses, if any, for the year. To the extent that such premiums are not so used, they are transferred, as part of the FSLIC's net income for the year, to the ‘Primary Reserve,‘ the FSLIC's general reserve which contains its cumulative net income or ‘retained earnings' and which is available to meet the FSLIC's insurance losses if its income in any year is insufficient for this purpose. Section 1727(d) payments, on the other hand, are not considered as income by the FSLIC, and are not ordinarily available to meet the annual expenses and losses of the Corporation. Instead, the FSLIC is required by statute to credit all such payments directly to a ‘Secondary Reserve,‘ which is to be used ‘only for losses of the Corporation and shall be so available only to such extent as other accounts of the Corporation which are available therefor are insufficient for such losses.’ Sec. 1727(e). Thus, instead of being taken into income, freely available to meet expenses and losses of the current year, the section 1727(d) payment is credited directly to an account, rather like a capital account, which may be applied against losses only on the event that the regular insurance premiums for the year, the Corporation's other income, and its retained earnings of prior years have all been depleted. It cannot, therefore, be accurately termed a premium for insurance coverage in the year of payment, but, at least initially, is in reality a capital investment in the FSLIC, part of a pool of capital available to the FSLIC for the payment of losses in the event of emergency.
Furthermore, when the regular insurance premiums paid by insured institutions under section 1727(b)(1) are received by the FSLIC, they lose their distinctive character as premiums and become merely part of the gross income of the Corporation; the insured institution retains no rights in respect of such sums, other than the right to insurance coverage for the current year, and its premium, once paid, is lost to it forever. Payments made under section 1727(d), however, stand on quite a different footing. Such payments, as noted above, are immediately segregated in the ‘Secondary Reserve,‘ and the FSLIC is directed by statute to credit the outstanding balance in this account, on ann annual basis, with a ‘return’ computed ‘at a rate equal to the average annual rate of return to the Corporation * * * on the investments held by the Corporation in obligations of, or guaranteed as to principal and interest by, the United States.’ Sec. 1727(e). What is more, each insured institution maintains an interest in a prorata share of the Secondary Reserve, and is annually furnished with a statement of its account by the FSLIC, which keeps a separate account for each insured institution. That annual statement discloses all section 1727(d) payments made by the insured institution, the interest or return earned by the account, any debits that may have been charged against the account, and, finally, the new balance in the account as of the end of the year. Thus, for the years 1962-67, petitioner's account, set forth in our findings, reflects various credits (section 1727(d) payments and interest or return), no debits, and a balance of $4,922,115.46 in its favor, representing its prorata share in the Secondary Reserve as of December 31, 1967.
While petitioner's prorata share of the Secondary Reserve is not, as a general rule, assignable or transferable, ‘by operation of law or otherwise,‘ the value of such share may be fully realized through its transfer to another insured institution in a merger, consolidation or bulk sale; petitioner may even receive the value of its share from the FSLIC in cash if (1) its insured status is terminated, either voluntarily or involuntarily, (2) it goes into liquidation, voluntarily or involuntarily, or (3) the obligation to make section 1727(d) payments is permanently terminated and the Secondary Reserve distributed before the value of its share has otherwise been fully recovered. See p. 98, infra. Moreover, assuming petitioner does not realize the value of its prorata share in one of the above ways, it is reasonably assured of receiving full value therefor in the form of insurance coverage in future years when its share of the Secondary Reserve is used to pay its regular section 1727(b)(1) premiums. To the extent that petitioner's share is so used, entries will undoubtedly be made in the debit column of its account which will be reflected in the balance appearing as of the end of each such year. Also, to the extent that any losses may be charged in any year against the Secondary Reserve, petitioner's prorata share thereof should similarly appear in the debit column, thereby also adversely affecting its balance as of the end of such year. And to the extent that any such debits are charged against petitioner's balance in any particular year, whether for regular section 1727(b)(1) premiums or for losses, it would seem that petitioner would be entitled to deductions in those amounts for any such year. Cf. Rev. Rul. 66-49, 1966-1 C.B. 36, 37.
As already noted, the Secondary Reserve is available for the payment of losses, but only to a very limited extent. It has, however, never been used for this purpose, nor, on the basis of the FSLIC's past loss experience, does such use appear to be likely. At the time that Congress considered Public Law 87-210, in 1961, net insurance losses of the FSLIC had absorbed only 1.1 percent of its gross income over its entire existence, H. Rept. No. 823, 87th Cong., 1st Sess., p. 2 (1961); S. Rept. No. 778, 87th Cong., 1st Sess., p. 2, and the financial statements of the FSLIC put in evidence by the parties, covering all the years thereafter through December 31, 1967, reveal no year in which the net insurance losses of the FSLIC exceeded even its investment income, much less the annual premiums for the year and/or the Primary Reserve, both of which must be fully consumed before the Secondary Reserve can be utilized. The Primary Reserve alone stood at $921,669,395 on December 31, 1967, while the cumulative net losses of the FSLIC from June 27, 1934, through December 31, 1967, totaled only $105,610,365. Of course, an event of catastrophic proportions, another Great Depression, could conceivably wipe out the Secondary Reserve, but the probability that such an event will occur is simply incalculable. It is certainly not an event that could reasonably be anticipated as of any particular time, and if any event should occur requiring a charge against the Secondary Reserve in respect of any loss, petitioner's prorata share thereof would then be deductible, as has already been pointed out. But there do not appear to be any greater hazards in this respect than attach to the capital investment made by a stockholder in a commercial bank or an insurance company.
Though it is clear that ‘prepayments' under section 1727(d) are not really insurance premiums, at least not in the year in which they are paid, a further examination of the provisions of Public Law 87-210 also reveals sharp differences between such ‘prepayments' and the ordinary prepaid insurance premium. While the average prepaid insurance premium gives rise to an obligation on the part of the insurer to provide coverage for some definitely ascertainable period of time, usually not more than 2 or 3 years from the date of the policy, the FSLIC incurs no such obligation upon its receipt of a section 1727(d) payment. The obligation to provide insurance coverage does not arise until the section 1727(d) payment is actually used to discharge the obligation of the insured institution to pay a regular section 1727(b)(1) insurance premium, which event is contingent upon the ratio of the FSLIC's reserves to its potential liabilities attaining certain levels. Moreover, since the section 1727(d) payment credited to the Secondary Reserve is subject to accretion through the annual ‘return’ credited annually by the FSLIC on the outstanding balance in such reserve, and at least theoretically to depletion in the event the reserve is used to meet losses in an emergency situation, and since the regular annual premium required by section 1727(b)(1) is itself a percentage of the insured institution's accounts and creditor obligations, and thus varies from year to year, there is no way of predicting with certainty the number of years of insurance coverage which will be procured by each section 1727(d) payment, much less the precise years which will be covered. Thus, unlike the common prepaid insurance premium, the section 1727(d) payment is not simply ‘an exhaustible asset with a determinable life’ whose value may be allocated ‘ratably over the term for which the premium is paid,‘ see George S. Jephson, 37 B.T.A. 1117, 1120; Higginbotham-Bailey-Logan Co., 8 B.T.A. 566, 577; the life of the asset created by the section 1727(d) payment is not determinable on the date of payment, and its usefulness will not be ratably spread over the period of that life.
For the period of time prior to its use to discharge the obligation of the payor institution to pay regular annual premiums required by section 1727(b) (1), the section 1727(d) payment will simply constitute part of the capital of the FSLIC. Under the terms of the statute, section 1727(g), the prorata share of each insured institution in the Secondary Reserve will be used to pay its regular annual premiums, and the obligation of insured institutions to make section 1727(d) payments will concurrently be suspended, only after the aggregate of the FSLIC's Primary and Secondary Reserves equals or exceeds 2 percent of the total amount of all savings accounts and creditor obligations of institutions insured by the FSLIC. The obligation to make section 1727(d) payments will, however, resume, if the aggregate of the two reserves subsequently falls below 1 3/4 percent of the FSLIC's potential liabilities, and, until such aggregate again reaches the 2-percent level, the use of the prorata share of each insured institution to pay its regular annual premiums must also cease. It is not until the FSLIC's Primary Reserve alone equals or exceeds 2 percent of its potential liabilities that the obligation to make section 1727(d) payments will permanently terminate, at which time insured institutions are entitled to the refund of their prorata share of any amount remaining in the Secondary Reserve. Clearly then, the effect of these provisions is to require insured institutions to make and keep capital investments in the FSLIC, until it has retained enough of its own earnings (in the Primary Reserve) to provide, in the opinion of Congress, adequate protection for insured savers.
To be sure, the asset acquired by petitioner by virtue of its section 1727(d) payments, i.e., its prorata share of the FSLIC's Secondary Reserve, differs in many respects from the usual capital investment. Petitioner is required by law to make the investment, at least as long as it wishes to insure its accounts with the FSLIC, cf. Hotel Sulgrave, Inc., 21 T.C. 619, the amount of the investment is determined by the growth of its business, i.e., the increase in its savings accounts, and the asset so acquired is ordinarily not transferable to others. But these differences, though perhaps not insignificant for other than tax purposes, cannot alter the fact that the section 1727(d) payment does not actually provide insurance coverage for petitioner in the year of payment, and is not an ordinary and necessary expense of that year; it results in the acquisition of an asset which, if held to ‘maturity’ and not transferred in a merger, consolidation, or bulk sale, and not refunded in the event of a termination of insurance or liquidation, will result in benefits, in the form of insurance coverage, in future years. In these circumstances, it is a matter of no consequence whether petitioner is a cash or accrual basis taxpayer, for the rule is the same for both that: ‘If an expenditure results in the creation of an asset having a useful life which extends substantially beyond the close of the taxable year, such an expenditure may not be deductible, or may be deductible only in part, for the taxable year in which made.’ Sec. 1.461-1(a) (1) and (2), Income Tax Regs. Moreover, we need not look far to find a similar investment which, though possessing many of these same peculiar attributes, is nevertheless a capital expenditure. An example readily at hand lies in the payment by petitioner of amounts required by section 6 of the Federal Home Loan Bank Act, 12 U.S.C.sec. 1426(c), for the acquisition of capital stock in its Federal home loan bank, a payment which we think is closely analogous to the section 1727(d) payment here, and which petitioner has consistently capitalized rather than expensed in the year of payment.
Membership in a Federal home loan bank entitles a savings and loan association to obtain advances from such bank, up to certain limits, upon the security of its home mortgages and obligations of or guaranteed by the United States, 12 U.S.C.sec. 1430(a); it thus serves the important function of providing members with a source of additional liquidity and funds for mortgage lending. As a condition of membership, the savings and loan association must initially purchase stock in one of 12 regional home loan banks, depending upon the district in which it is located, equal to 1 percent of such association's ‘aggregate unpaid loan principal,'
and must purchase such additional amounts of stock thereafter as is necessary to maintain this ratio at the close of each succeeding calendar year, 12 U.S.C.sec. 1426(c)(1). Amounts so invested are not ordinarily transferable, and, in general, are returnable to the member only upon its withdrawal from membership. Also, if at the time of withdrawal the FHLB Board finds that the paid-in capital of the member's Federal home loan bank is or is likely to be impaired as a result of losses in or depreciation of the assets held by such Federal home loan bank, the amount to be paid the member in retirement of its stock is reduced by its prorata share of the amount of the impairment. 12 U.S.C.sec. 1426(i). The similarities between the mandatory payments made by petitioner to its Federal home loan bank and those made to the FSLIC are thus strikingly apparent.
Defined as the aggregate unpaid principal of its home mortgage loans, home-purchase contracts, and similar obligations. 12 U.S.C.sec. 1426(c)(4).
True, petitioner did not receive any pieces of paper to evidence its prorata share of the Secondary Reserve, though one could imagine a redeemable preferred stock which incorporated all the provisions of sections 1727(d), (e), (f), and (g) as described above, which might have been issued in exchange for such payments. But it acquired an asset nevertheless, if evidenced only by the annual statements sent to petitioner every year showing the status of such prorata share. That the section 1727(d) payment made to acquire that asset was mandatory and based upon the volume of petitioner's business, and that the asset itself was nontransferable and subject to a limited extent to the losses of the corporation in which the funds were invested, does not make it any more an ordinary and necessary expense, nor less a capital expenditure, than the required investments made by petitioner in its Federal home loan bank.
Petitioner argues that the legally compelled investments made in its Federal home loan bank are fundamentally distinguishable from the sec. 1727(d) payments here by virtue of the fact that it is entitled to dividends on its Federal home loan bank stock which are immediately available for its use, and the further fact that the Federal home loan bank may, ‘in its discretion,’ retire the stock of any member to the extent that it exceeds the required ratio. Although these are distinctions, they are nevertheless distinctions without a difference here. We do not consider it significant that petitioner's annual dividends on its Federal home loan bank stock are distributed to it rather than being credited to its account, nor do we think it important that petitioner may receive some of the funds invested in the Federal home loan bank before it begins to receive, actually or constructively, its sec. 1727(d) payments. Moreover, assuming that it remains a member of both the Federal home loan bank and the FSLIC indefinitely, petitioner will certainly receive its total investment in the FSLIC before it receives the money it has invested in its Federal home loan bank, for while there is a definite limit on petitioner's commitment to the FSLIC, there is none on its commitment of funds to the Federal home loan bank. At any rate, the question of when such investments, or the return thereon, will be redeemed is simply a question of timing; the important point is that both are in fact capital investments.
Moreover, the section 1727(d) payments, which are measured by the net increase of the institution's insured accounts during the preceding year, were in fact regarded by Congress, in part at least, as being a substitute for investments in the capital stock of the Federal home loan banks which member institutions were theretofore required to make. A member institution was formerly obligated to purchase and hold such capital stock equal to 2 percent of its outstanding home mortgage loans, but when its obligation to make the section 1727(d) payments commenced in 1962, the 2-percent level in respect of the capital stock was simultaneously reduced to 1 percent. It is clear that Congress regarded these as interrelated events,
and in our judgment the 1727(d) payments represented capital outlays by the member institution just as much as its investment in the stock of its regional Federal home loan bank.
See infra, p. 102.
The legislative history of Public Law 87-210, which amended section 1727 to its present form in 1961, does not of course deal with the manner in which section 1727(d) payments should be treated for Federal tax purposes, but it is certainly not inconsistent with anything we have said here. The decade preceding the enactment of the bill witnessed a tremendous increase in the growth of institutions insured by the FSLIC, and a concomitant growth in the total amount of savings insured by the Corporation. But, in that same decade, the FSLIC was required by Congress to use its income to retire all of its capital stock, in the amount of $100 million from the U.S. Treasury. The result was a decline in the ratio of the reserves of the FSLIC to its potential liabilities during this period from 0.843 percent to 0.661 percent. See S. Rept. No. 778, 87th Cong., 1st Sess., pp. 2, 12; Hearings before House Subcommittee No. 1, Committee on Banking and Currency on H.R. 7108 and H.R. 7109, 87th Cong., 1st Sess., pp. 10, 39. Public Law 87-210 was ‘designed to add new strength’ to the FSLIC by requiring insured institutions to make so-called ‘premium prepayments' which, it was hoped, ‘would result in a marked acceleration in building up the Corporation's Reserves.’ H. Rept. No. 823, 87th Cong., 1st Sess., p. 2 (1961); S. Rept. No. 778, supra at 1-2.
Petitioner emphasizes that Congress spoke in terms of building up the FSLIC's reserves, that section 1727(d) payments are in fact credited to a ‘Secondary Reserve,‘ and concludes that a necessary corollary is that payments made to a reserve must be insurance premiums. This is no more than semantic word play. The truth of the matter is that, for the reasons outlined at the beginning of this opinion, section 1727(d) payments cannot be considered merely additional insurance premiums. Had Congress felt that the premium income of the FSLIC was inadequate to meet expenses and losses, it could easily have increased the regular annual premium to what it considered a more realistic level, without enacting all the complicated provisions which govern section 1727(d) payments. But, in fact, during the entire life of the corporation its total expenses had, to 1961, amounted to only 3.7 percent of its gross income while net insurance losses had absorbed ‘a mere 1.1 percent of the gross income.’ Hearings, supra at 10. Cf. H. Rept. No. 823, supra at 2; S. Rept. No. 778, supra at 2. What was needed was additional capital, not additional premium income, which would serve as a buffer until the FSLIC had accumulated enough of its own income to bring its ‘Primary Reserve,‘ the true insurance reserve, to the desired 2-percent level.
True, Congress called the account to which this additional capital was credited a ‘Secondary Reserve,’ but since such ‘reserve’ served the same function as a capital account, and was available for losses ‘only to such extent as other accounts of the Corporation which are available therefor are insufficient for such losses, ‘ Congress' use of the terminology of the insurance industry should not confuse the issue. And what, after all, is the capital account of any corporation if not a ‘Secondary Reserve,‘ a pool of capital available to creditors in the event that the corporation's current income and retained earnings are not sufficient to satisfy their claims?
Compare the statement of Everett C. Sherbourne, vice chairman, Federal Legislation Committee, National League of Insured Savings Associations. Hearings, supra at 45. ‘From the standpoint of the loss experience of the Corporation, we do not believe the reserve would be inadequate. * * * There is, however, an inadequacy of working capital.’ This witness went on to explain that the FSLIC does not ‘sit idly by, wait for a loss to occur, and then pay out insurance,‘ but has authority to take steps, such as the making of loans to institutions in danger of failing, which ‘may involve substantial cash disbursements without ultimate loss to the Corporation.’The savings and loan industry supported Public Law 87-210, see S. Rept. No. 778, 87th Cong., 1st Sess., pp. 5, 12-13, in line with its ‘longstanding position’ that savings and loan associations should finance ‘their Insurance Corporation’ rather than ‘rely on taxpayer funds for this purpose.’ See S. Rept. No. 378, 89th Cong., 1st Sess., pp. 71-72 (1965).
As has previously been pointed out, at the same time and in the same measure directing insured institutions to make these additional section 1727(d) payments to the FSLIC, Congress reduced the ratio of stock which members of a Federal home loan bank were required to hold against their ‘unpaid loan principal’ from 2 to 1 percent. It was contemplated that ‘For most institutions, this prepayment requirement (i.e., sec. 1727(d) payments) would be approximately offset by reducing the stock the institution must purchase in its Federal home loan bank.’ See H. Rept. No. 823, supra at 2; S. Rept. No. 778, supra at 1-2. In essence, then, Public Law 87-210 provided that funds which would otherwise have gone into the capital structure of the Federal home loan banks, which already had ‘more than sufficient (amounts invested in capital stock) to meet the criterion of adequate capitalization,‘ see Hearings, supra at 9, would be channeled instead to the FSLIC's Secondary Reserve, which is itself essentially a capital account, though more temporary in nature. Moreover, to the extent that an insured institution is required to purchase additional stock in its Federal home loan bank, its section 1727(d) payment to the FSLIC is reduced by the amount of stock so purchased. Clearly, if the section 1727(d) payments represented actual insurance premiums needed by the FSLIC to meet its expenses and losses, rather than merely a capital cushion for the FSLIC, this arrangement would not have been feasible. The fungibility of capital stock payments to the Federal home loan bank and section 1727(d) payments to the FSLIC under Public Law 87-210 strongly suggests that Congress thought of both as serving roughly the same purpose.
The conclusion then, is inescapable that section 1727(d) payments result in the creation of an asset in the nature of a capital investment which should, however, eventually be used to provide insurance coverage in future years, and that for Federal income tax purposes at least, such payments must be capitalized and deducted from gross income only in the years and to the extent actually used to provide such insurance coverage or actually drawn upon to meet losses. Sec. 1.461-1(a), Income Tax Regs. Nor are we convinced by petitioner's argument and the testimony of its expert witnesses that, as a matter of general accounting practice a section 1727(d) payment should be written off immediately because of uncertainty as to whether and when it will benefit the insured institution. We have already demonstrated that, for all practical purposes, these payments will definitely be used to discharge the obligation of the insured institution to pay regular annual premiums in future years, assuming it has not previously transferred its prorata share of the Secondary Reserve or received a cash payment in respect thereof from the FSLIC. Even the years in which the Secondary Reserve will be available for such use are not wholly a matter of conjecture, for the Office of the Comptroller of the FSLIC has made projections in this regard, showing, inter alia, that the aggregate of the Primary and Secondary Reserves of the FSLIC will equal or exceed 2 percent of the FSLIC's potential liabilities by 1970, and will thereafter be available for payment of regular annual premiums in subsequent years (except those in which the aggregate of the reserves falls below 1 3/4 percent of the FSLIC's potential liabilities, as disclosed in the projection) until 1995, when the Primary Reserve is expected to equal or exceed the 2-percent ratio by itself.
See Findings of Fact, p. 90, supra.
The projections made by the FSLIC are, of course, based on a number of assumptions, and are not infallible. Still, they have been proven relatively accurate for the first 5 years since the enactment of Public Law 87-210, and, in its annual report for 1966, the FHLB Board (which administers the FSLIC) stated that it expected the aggregate of the Primary and Secondary Reserves to reach the 2-percent level by 1971, as compared to the prediction of 1970 in the original FSLIC estimate. To be sure, these estimates will not allow an insured institution to compute with pinpoint accuracy the years in which its sec. 1727(d) payments will be used to provide insurance coverage, but they do at least allow it to make a rough approximation.
Moreover, the fact of the matter is that both the California savings and loan commissioner and the FHLB Board require that section 1727(d) payments be capitalized and shown on the financial statements of insured institutions as an asset, to be expensed only in the years in which actually used to satisfy the insured institution's obligation to pay a regular section 1727(b) insurance premium. It is, of course, well established that methods of accounting prescribed by regulatory agencies are not controlling for Federal tax purposes, Old Colony R. Co. v. Commissioner, 284 U.S. 552, 562; Bellefontaine Federal Savings & Loan Association, 33 T.C. 808, 811-812, but where, as here, the accounting treatment prescribed for a particular expenditure appears to be prompted not by any particular statutory or regulatory requirements (indeed, it would seem that agencies charged with the supervision of financial institutions would be quite anxious that the assets and net income of such institutions not be overstated) but rather to be based upon sound accounting principles, it should not be wholly disregarded. Furthermore, the financial statements of both petitioner and its parent, the First Lincoln Financial Corp. reported the section 1727(d) payments here in issue as assets, not expenses, and the firm of certified public accountants which audited such financial statements was able to state, in the accountant's report preceding such financial statements, that they presented fairly the financial position of petitioner and its parent ‘in conformity with generally accepted accounting principles.’
We are aware that the same issue that confronts us here was raised, and recently decided in favor of the taxpayer, in First Federal Savings & Loan Assn. of St. Joseph v. United States, (W.D. Mo. 1968) 22 A.F.T.R.2d 5238, 68-2 U.S.T.C.par. 9490,
the only case in which the issue herein has been adjudicated. The District Court there refused to follow Rev. Rul. 66-49, 1966-1 C.B. 36, in which it was stated that section 1727(d) payments were not deductible as ordinary and necessary expense. The court held that section 1727(d) payments were deductible in the year of payment, relying on the fact that insured institutions are ‘subject to the basic liability’ to make such payments, that the funds were ‘paid with respect to insurance coverage and * * * (were) based, to a certain extent, upon the risk of loss,‘ and ‘of even more significance,‘ upon the fact that such payments ‘were subject to being completely consumed in the event of a loss.’ We have already expressed our opinion on these matters, and, being of the view that section 1727(d) payments are nondeductible capital expenditures, we respectfully decline to follow the holding of the District Court. Though we prefer to rest our holding upon the reasons set forth in this opinion, we do agree with the conclusion reached in Rev. Rul. 66-49 that section 1727(d) payments are not ordinary and necessary expenses in the year of payment and are not deductible until they are used to pay regular premiums or losses, or the possibility of their return to the institutions is otherwise precluded. Rev. Rul. 66-49, 1966-1 C.B. 36, 37.
That case involved a Federal savings and loan association which, unlike petitioner, a State-chartered association, was required and not merely permitted to insure its accounts with the FSLIC. Thus, it did not have the option, available to petitioner, of terminating its insured status without going into liquidation, while petitioner, theoretically at least, could cease being an insured institution of the FSLIC, receive its prorata share of the Secondary Reserve in cash, and still remain in business. We need not discuss further whether this alternative was open to petitioner as a practical matter, and do not express any opinion as to the significance of this distinction, for our disagreement with the District Court's opinion goes to the more basic issue of the inherent nature of the sec. 1727(d) payment.
It was also held in Rev. Rul. 66-49 that the annual return credited to each insured institution on amounts in its prorata share of the Secondary Reserve does not constitute taxable income to an insured institution on the cash basis until actually or constructively received by it, either by way of refund or by its use to discharge the insured institution's obligation to pay annual premiums. Petitioner, while of course not disparaging the Commissioner's position on this matter, claims it is inconsistent with his position on the deductibility of the sec. 1727(d) payments. The question of when this annual ‘return’ must be included in the income of a cash basis taxpayer is not now before us, and we express no opinion thereon. We do note, however, that the position we take here, that sec. 1727(d) payments are nondeductible capital expenditures, is not inconsistent with the Commissioner's position as to the time for inclusion of the annual return in income.
Because of the unusual nature of the section 1727(d) payments in issue, the remaining cases and rulings cited by both petitioner and respondent are, for the most part, distinguishable on their facts. Thus, cases cited by petitioner for the proposition that an ordinary and necessary business expense is not rendered nondeductible because there remains after payment a contingent possibility of future recovery, e.g., Alleghany Corporation, 28 T.C. 298, 305; Electric Tachometer Corporation, 37 T.C. 158; and cf. I.T. 2764, XIII-1 C.B. 45; I.T. 3632, 1943 C.B. 114;
Rev. Rul. 62, 1953-1 C.B. 71, are of no help to petitioner here since it failed to establish the necessary initial foundation required by these cases; i.e., that the amount of $882,636.86 paid by it to the FSLIC in 1963 pursuant to section 1727(d) constituted an ordinary and necessary expense of that year. Cf. Harry W. Williamson, 37 T.C. 941, 944. Nor, on the other hand, were these payments merely security deposits in the nature of a reserve for contingent liabilities as suggested by respondent. Cf. Spring Canyon Coal Co. v. Commissioner, 43 F.2d 78 (C.A. 10), certiorari denied 284 U.S. 654; Wayne Title & Trust Co. v. Commissioner, 195 F.2d 401 (C.A. 3); Wolfington Body Co. v. Smith, 99 F.Supp. 788 (E.D. Pa.). Compare Weber Paper Co. v. United States, 204 F.Supp. 394 (W.D. Mo.), affirmed 320 F.2d 199 (C.A. 8), with Rev. Rul. 60-275, 1960-2 C.B. 43. Perhaps most closely approximating the situation in this case are those cases and rulings involving payments made by Texas State banks during the 1920's to the Texas State Depositor's Guaranty Fund, which, because they shed some light on the section 1727(d) payments involved herein, we now set forth in some detail.
I.T. 2764, relied upon by petitioner, was declared obsolete in Rev. Rul. 68-100, 1968-1 C.B. 572. It involved payments made to a temporary insurance fund set up by the Federal Deposit Insurance Corporation in the first days of its creation, and relied upon G.C.M. 8474, IX-2 C.B. 281 which was shortly thereafter revoked by the Commissioner. G.C.M. 13290, XIII-2 C.B. 313. See text concerning the Texas State Depositor's Guaranty Fund, pp. 105-106, infra. I.T. 3632, another ruling cited above upon which petitioner relies, cited as its only authority I.T. 2764. Both I.T. 2764 and I.T. 3632, however, are also distinguishable on their facts, as is noted above.
Texas statutes required every State bank to protect its depositors either by a bond or policy of insurance, or by becoming a contributor to the Depositor's Guaranty Fund. If the latter method was elected, the bank was required to make annual contributions to the fund based upon its average deposits, one-fourth in cash to the State treasury on which the bank was entitled to interest, though not payable until its liquidation or withdrawal from the fund, and three-fourths as a deposit on its books to the credit of the State banking board. These ‘regular contributions' were to continue until the fund contained $5 million. If a contributing bank failed, whatever money was needed to pay its depositors was taken from the fund, which was then immediately reimbursed by a special cash assessment levied on the contributing banks. Such ‘special assessments' could not exceed 2 percent of a bank's total average daily deposits in any 1 year, so that, in any year in which losses exceeded this amount, recourse was had to the fund itself, and the ‘regular contributions' to the fund would resume until it again reached $5 million. Each participating bank's prorata share of the fund was returnable to it upon its withdrawal from the fund or upon its liquidation.
The proper treatment to be accorded the regular contributions to the fund for Federal income tax purposes became a matter of some controversy. The Bureau of Internal Revenue first held that they were deductible as ‘necessary business expenses,‘ I.T. 1258, I-1 C.B. 281, but soon revoked this ruling in I.T. 2208, IV-2 C.B. 81. The position was then taken that the contributions were not deductible since they ‘remain assets of such participating banks. Each participating bank retains at all times an interest in the fund equal to the unexpended portion of its contributions thereto, the amount whereof is readily determinable * * * .’ S.M. 3877, IV-2 C.B. 79. The Board of Tax Appeals did not agree with this approach, holding in First State Bank of Bracketville, 9 B.T.A. 975, followed in First State Bank of Weimar, 10 B.T.A. 396, that such contributions were deductible since they were paid ‘pursuant to a definite liability fixed by law.’ First State Bank of Bracketville, 9 B.T.A. 975, 980. The Bureau thereupon modified its position to conform to that of the Board of Tax Appeals. G.C.M. 8474, IX-2 C.B. 281.
However, the Board was again confronted with this issue in Wichita State Bank & Trust Co., 27 B.T.A. 822. In that case, the taxpayer bank had withdrawn from the fund and had received its prorata portion thereof, and the issue raised was whether such amount was includable in its income. The Commissioner said it was, relying on his newly revised position on this matter following the Bracketville and Weimar cases, contending that since the regular contributions to the fund were deductible, their return to the taxpayer constituted taxable income. The Board, following its prior decisions, agreed. On appeal, in an opinion which we now think correctly disposed of this matter, the Fifth Circuit reversed the Board on this issue, holding that the regular contributions were not ordinary and necessary expenses but nondeductible capital expenditures. Wichita State Bank & Trust Co. v. Commissioner, 69 F.2d 595 (C.A. 5). Keeping in mind the similar characteristics of these ‘regular contributions' and the section 1727(d) payments here in issue, the following comments of the Fifth Circuit are instructive (69 F.2d at 596):
That fund (i.e., the permanent five million dollar Guaranty Fund) is not intended to be lost or consumed, but is to stand as a reservoir drawn on to provide prompt payment to depositors, but to be at once replenished by the special assessments. It is analogous to the capital of an insurance company. Each bank owns its pro rata part in it, which it sought ultimately to get back. * * * We think the contributions to the $5,000,000 Guaranty Fund, while made annually instead of in a lump sum, were essentially capital investments and ought to be dealt with as such. * * *
Here the matter of the ‘regular contributions' was finally settled, the Commissioner indicating agreement with the Fifth Circuit's opinion by reinstating S.M. 3877, G.C.M. 13290, XIII-2 C.B. 313.
We hold that the section 1727(d) payment of $882,636.86 made by petitioner in 1963 was a nondeductible capital expenditure, that the Commissioner correctly disallowed a deduction for this sum, and that the deficiency determined in petitioner's income tax for 1963 in respect of that disallowance was proper.
Petitioner has made an alternative argument that the Commissioner's attempt to assess and collect the deficiency here violated its constitutional rights under either article II, section 3 (directing the President to ‘take care that the laws be faithfully executed’), or the fifth amendment to the Constitution (the due process clause). Petitioner relies on the fact that in the First Federal Savings & Loan Assn. of St. Joseph case, discussed above, a tax refund suit in which the taxpayer savings and loan association sued to recover taxes which it alleged were erroneously paid for 1963, 1964, and 1965 due to its failure to deduct section 1727(d) payments made in those years, the Government tried to settle by offering to pay the amount sought by the taxpayer and to dismiss the action with prejudice, though it did not wish the terms of the settlement to be included in the final stipulation. It should be noted that the taxpayer refused this offer, and the District Court went to extraordinary lengths in ruling that the refund suit had not become moot. The District Court thereupon adjudicated the issue on the merits in the taxpayer's favor. Petitioner nevertheless contends that the mere fact that the offer of settlement was made to the taxpayer in the St. Joseph case is fatal to the determination of the deficiency herein on constitutional grounds. We think that the point is without merit.
The position taken by the Commissioner in this case in respect of section 1727(d) payments made to the FSLIC is the same as that in Rev. Rul. 66-49, published in 1966-1 C.B. 36. We have carefully examined that position, as it relates to the facts of this case, and have found the deficiency determined by the Commissioner in petitioner's income tax for 1963 was justified by the provisions of the Internal Revenue Code of 1954. We cannot and will not go further and examine the Commissioner's reasons and motives for determining the deficiency in this case and defending his position in response to the petition for a redetermination filed by petitioner in this Court. See Charles Crowther, 28 T.C. 1293, 1301, reversed and remanded on other grounds 269 F.2d 292, 293 (C.A. 9). Petitioner has no ground to object merely because some other taxpayer may have been offered a windfall as a result of the Government's litigation strategy. Whatever may have been the Government's litigation strategy in attempting to dispose of the St. Joseph case, it is not a matter about which the petitioner herein has any standing to complain. The history of litigation over the years has been marked by efforts of private litigants as well as the Government to select test cases in such manner as may be thought to further their respective best interests, and the refusal to press some other case has never been thought to create any rights in favor of parties to a case where similar concessions have not been made. Petitioner has been accorded due process of law in the review of the deficiency determined against it by the Commissioner herein and the fact that it has not been offered a windfall, if indeed the offer of settlement in the St. Joseph case was such, does not rise to the level of an infringement of its constitutional rights.
Reviewed by the Court.