221 F.

2d 944

COMMISSIONER OF INTERNAL REVENUE, Petitioner,

v.
The BAGLEY & SEWALL CO., Respondent.
No. 109.
Docket 23096.

United States Court of Appeals Second Circuit.

Argued February 15, 1955.
Decided April 21, 1955.

H. Brian Holland, Asst. Atty. Gen., Ellis N. Slack, Hilbert P. Zarky and
Morton K. Rothschild, Sp. Assts. to Atty. Gen., for petitioner.
Dunk, Conboy, McKay & Bachman, Watertown, N. Y. (Lawrence
Conboy, Watertown, N. Y., of counsel), for respondent.

Before FRANK and MEDINA, Circuit Judges, and BRENNAN, District Judge.

BRENNAN, District Judge.

Whether or not the loss incurred in the posting of U. S. Government bonds as

security for the performance of a contract is a capital loss or a business expense
is the question posed on this appeal.

A background of essential facts were submitted by stipulation to the Tax Court.

The Bagley & Sewall Co. (hereinafter referred to as the taxpayer), is a New
York corporation engaged in the manufacture and sale of paper making
machinery. In 1946 the taxpayer entered into a contract with a corporation
acting in behalf of the Government of Finland for the manufacture and delivery
of two paper making machines at a cost of approximately $1,800,000.
Payments were to be made periodically during the progress of manufacture.
The Government of Finland required that U. S. 2% Government bonds be
deposited with a New York financial institution as security for the performance
of the contract and in accordance with an agreement which provided for the

return of the bonds to Bagley & Sewall upon receipt of the last payment due
under the contract. The above provisions were incorporated in and made a part
of the contract. The taxpayer did not have or own the required bonds and in
order to carry out the provisions of the contract, U. S. Government bonds in a
total face value of $800,000 were purchased by the taxpayer with moneys
borrowed for that purpose and same were deposited as required by the contract,
the total cost of same being $820,062.50. The interest earned upon the bonds
during the period that they were held in escrow was reported as income
received by the taxpayer. In accordance with the terms of the contract, the
bonds were released in two lots, one of $400,000 face value on Sept. 7, 1948
and one of $400,000 face value on Sept. 22, 1948. The bonds were sold by the
taxpayer in each instance a few days after their release resulting in a loss of
approximately $15,000 which the taxpayer claimed, in its tax return for 1948,
as an ordinary and necessary business expense. During the period that the
bonds were held in escrow and until they were sold, they were carried in the
general ledger of the taxpayer in an account entitled "U. S. Gov't. Bonds" and
on its balance sheet of Dec. 31, 1946 and Dec. 31, 1947, the bonds were shown
under the caption "U. S. Gov't. Bonds".
5

Upon re-audit, the Commissioner of Internal Revenue determined a deficiency

in the taxpayer's 1948 return on the ground that the above loss was a capital
loss under Section 117(a) (1) of the Internal Revenue Code of 1939, 26 U.S.
C.A. The matter came on before the Tax Court and after making minor
adjustments, which are not here in dispute, the Tax Court found in effect in
accordance with the claim of the taxpayer that the sale of the bonds was of
assets held for sale in the ordinary course of petitioner's business and the loss
was deductible as an ordinary and reasonable business expense.

The findings made are substantially as outlined above with the following
additions * * * that the taxpayer was not in the business of buying and selling
securities, that its available cash reserve was necessary for working capital, that
it is clear that no investment in U. S. bonds was intended by the petitioner, they
were acquired solely to carry out a condition imposed by the contract. It was
concluded that the purchase and sale of these bonds was merely an incident in
the carrying on by the petitioner of its regular business of manufacturing and
selling paper making machines. The Tax Court relied upon the decisions in
Western Wine & Liquor Co., 18 T.C. 1090 and Charles A. Clark, 19 T.C. 48
and distinguished the case of Exposition Souvenir Corp. v. Commissioner, 2
Cir., 163 F.2d 283. This appeal followed.

Concisely stated, the contention by the Commissioner is that the bonds

constituted capital assets, as the term is defined in Section 117(a) (1) of the

Internal Revenue Code and that the loss sustained upon their sale is to be
treated as a capital loss to the extent of offsetting capital gains, none of which
are reported by the taxpayer and therefore the whole item is subject to
elimination.
8

The taxpayer's contention is to the effect that the whole transaction is merely an
incident required and made necessary in the performance of a contract
undertaken in the regular course of the taxpayer's business and is deductible
from gross income in its entirety by reason of the provision of Section 23(a) (1)
(A) of the Internal Revenue Code of 1939.

The difficulty with the Commissioner's contention is that in effect he urges that
the bond transaction should be considered independently of the contract of
which it is a definite part. This circuit in Helvering v. New Haven & S. L. R.
Co., 121 F.2d 985, at page 988 has held that a contract may not be thus
atomized.

10

In Exposition Souvenir Corp. v. Commissioner, 2 Cir., 163 F.2d 283, the

taxpayer was required to make an investment, related to, but not a part of the
concession contract. This is not the situation here. The contract represents a
complete business transaction, security of performance alone, not investment
was required. The cost of procuring that security cannot be distinguished from
ordinary premium expense of a surety company bond which is a usual item of
contractor's costs. The Exposition case may be further distinguished by the fact
that the debentures were treated as investments in the taxpayer's books and tax
returns and in that case the Tax Court made a finding that the debentures were
not held for sale in the ordinary course of business. There is no such treatment
of this transaction in this taxpayer's tax return and no such finding. It is implicit
that the Tax Court found that the bonds here were held for sale to purchasers as
soon as released from escrow and available for sale. In the Exposition case, an
investment was intended and the taxpayer relied upon the motive for the
investment for relief. Here there is a clear finding that no investment was
intended. The Taxpayer's lack of surplus capital, the interest return of the
bonds, the interest obligation of the loan and the almost immediate sale of the
bonds when available make such a finding imperative. The finding here in this
respect is similar to that made in Gilbert v. Commissioner, 1 Cir., 56 F.2d 361.

11

In brief, it is urged that the all inclusive language of Section 117 requires that,
since the bonds are "property", they must be treated as capital assets unless
exempted by the specific language of the Section. The argument carries with it
the necessary conclusion that the circumstances of the transaction, its factual
background, the necessities of the business involved and the intentions of

taxpayer are of no importance except in determining whether the bonds are

exempted under the Section. We are not persuaded that Section 23 is so
completely subordinate to Section 117 and we find no authority which goes so
far.
12

"Whether an expenditure is directly related to a business and whether it is

ordinary and necessary are doubtless pure questions of fact in most instances".
Commissioner of Internal Revenue v. Heininger, 320 U.S. 467, at page 475, 64
S.Ct. 249, at page 254, 88 L.Ed. 171. The purchase of stock in order to
terminate an agency contract was held to be business expense. Helvering v.
Community Bond & Mortgage Corporation, 2 Cir., 74 F.2d 727. The purchase
of stock in a non-profit corporation to aid business was held to be a business
expense. Commissioner of Internal Revenue v. The Hub, 4 Cir., 68 F.2d 349.
The purchase of stock of a liquor corporation in order to purchase liquor
therefrom was held to be business expense. Hogg v. Allen, D.C., 105 F.Supp.
12, affirmed, Edwards v. Hogg, 5 Cir., 214 F.2d 640, 644. We find similar
holdings by the Tax Court especially the two cases relied upon by that Court
and referred to above. The above authorities are cited here not to show that we
necessarily agree with the conclusions therein but as an indication that business
expense, Section 23, has been many times determined by business necessity
without a specific consideration of Section 117.

13

An appreciation of the particular situation, Welch v. Helvering, 290 U.S. 111,

at page 116, 54 S.Ct. 8, 78 L.Ed. 212, to which is applied the pertinent sections
of the law according to common understanding and experience, Helvering v.
Horst, 311 U.S. 112, 61 S.Ct. 144, 85 L. Ed. 75, is the measure of the law's
requirement.

14

We find no comparable authority wherein a contract is dissected and its

separate parts are subjected to application of particular sections of the Revenue
Law. The Tax Court was right in refusing to wrench this transaction from its
setting and its finding and conclusion is amply supported by evidence. To
decide otherwise is to apply the law so as to escape reality.

15

The decision is affirmed.

16

FRANK, Circuit Judge (dissenting).

17

Congress, in Section 23, prescribed the items which may be deducted in

computing net income. In Section 23(g) (1), it provided that "losses from sales
or exchanges of capital assets shall be allowed only to the extent provided in

section 117." Then, in Section 117, sub-paragraph (a) (1), Congress explicitly
defined "capital assets" to mean "property held by the taxpayer (whether or not
connected with his trade or business)". Had Congress stopped there, perhaps it
would be proper to do, as my colleagues do, i. e., to find in Section 23(a) (1)
(A) and (f) exceptions to the definition contained in Section 117(a) (1). But
Congress, in Section 117(a) (1), went on very explicitly to enumerate the
exceptions to the definition, by saying that the term "capital assets" does "not
include"
18

"stock in trade of the taxpayer";

19

"other property of a kind which would properly be included in the inventory of

the taxpayer if on hand at the close of the taxable year";

20

"property held by the taxpayer primarily for sale to customers in the ordinary
course of his trade or business";

21

"property, used in the trade or business, of a character which is subject to the

allowance for depreciation provided in Section 23(l)";

22

"an obligation of the United States or any of its possessions, or of a State or

Territory, or any political subdivision thereof, or of the District of Columbia,
issued on or after March 1, 1941, on a discount basis and payable without
interest at a fixed maturity date not exceeding one year from the date of issue";

23

"real property used in the trade or business of the taxpayer."

24

The property in the instant case does not fit into any of those exceptions. I think
that a court, facing such explicit statutory exceptions, has no power to invent
another by recourse to other general statutory provisions Section 23(a) (1)
(a) and (f) which do not refer to Section 117 and to which Section 117 does
not refer. See, e. g., United States v. Colorado & N. W. R. Co., 8 Cir., 157 F.
321, 332, 15 L.R.A., N.S., 167; Rybolt v. Jarrett, 4 Cir., 112 F.2d 642, 645;
Brooks v. St. Louis-San Francisco Ry. Co., 8 Cir., 180 F.2d 185, 187, 15
A.L.R. 2d 1154; Cunard S. S. Co. v. Mellon, 262 U.S. 100, 128, 43 S.Ct. 504,
67 L.Ed. 894; Spring City Foundry Co. v. Commissioner, 292 U.S. 182, 189,
54 S.Ct. 644, 78 L.Ed. 1200; Fairbanks, Morse & Co. v. Harvey, 114 Vt. 425,
47 A.2d 123, 126; Connecticut Light & Power Co. v. Walsh, 134 Conn. 128, 57
A.2d 128, 131, 1 A.L.R.2d 453. 1

25

The last clause of Section 117(a) (1) is illuminating: From "capital assets" it

25

The last clause of Section 117(a) (1) is illuminating: From "capital assets" it
excepts "real property" no other if "used in the trade or business of the
taxpayer". My colleagues, in effect, treat that clause as if it read "any property
used in the trade or business of the taxpayer." This, I think, an improper judicial
amendment of the statute.

26

The Tax Court found that the property here was "held for sale in the ordinary
course" of taxpayer's business. Assuming, arguendo, that this finding was
justified by the evidence, still it cannot help taxpayer. For the only exception in
Section 117(a) (1) which approximates that finding is "property held by the
taxpayer primarily for sale to customers in the ordinary course of his trade or
business". The Tax Court's finding significantly omits "primarily"; and, if it
had made a finding containing that word, the finding, on this record, would
have been "clearly erroneous."

27

In this Circuit, there are but two decisions which bear on this case: In
Exposition Souvenir Corp. v. Commissioner, 2 Cir., 163 F.2d 283, the taxpayer,
a concessionaire, purchased debenture bonds, of New York World's Fair 1939,
Inc., as required by a contract in which the Fair awarded concession rights to
the taxpayer corporation, held the debentures until six months after the close of
the Fair, and then sold them at a net loss. The taxpayer urged, in the alternative,
that the debentures were held for sale in the ordinary course of business or that
the loss constituted an ordinary and necessary business expense deductible
under I.R.C. 23(a) (1) (A). The Tax Court ruled against both contentions and
this court affirmed. The loss in that case, as in the case at bar, was a business
expense, in that the concessionaire would probably not have purchased World's
Fair debentures except to secure the concession. So here, taxpayer, in all
probability, would not have purchased government bonds but for the
expectation of contracting with the Finnish government. The bonds in both
cases were capital assets, and did not lose that status because their purchasers
were not primarily motivated by hopes of interest payments or a rise in their
market value. In the earlier case of Helvering v. Community Bond & Mortgage
Corporation, 2 Cir., 74 F.2d 727, per Manton, J., the taxpayer, in order to
extinguish a troublesome agency contract, bought up the capital stock of the
company with which it had contracted, re-issued the stock to dummy
stockholders, and promptly voted cancellation of the agency contract and the
dissolution of the company. This court allowed the cost of the capital stock to
be deducted as an ordinary and necessary expense of doing business. The
question was not raised whether the loss was a capital loss. Without discussion
of that question, the court treated the case just as if the taxpayer had directly
paid money for cancellation of an exclusive-agency contract. Such a decision
cannot serve as a precedent here. See Webster v. Fall, 266 U.S. 507, 511, 45
S.Ct. 148, 149, 69 L. Ed. 411: "Questions which merely lurk in the record,

neither brought to the attention of the court nor ruled upon, are not to be
considered as having been so decided as to constitute precedents." See also,
Helvering v. Cement Investors, 316 U.S. 527, 530 note 1, 62 S.Ct. 1125, 86
L.Ed. 1649; Bard-Parker Co., Inc., v. Commissioner, 2 Cir., 218 F.2d 52, 57.
28

Helvering v. New Haven & S. L. R. Co., 2 Cir., 121 F.2d 985, related not at all
to the question whether assets were or were not "capital assets" under Section
117, but solely to the application of the reorganization provisions of the statute.
There the Commissioner attempted to isolate particular steps in a reorganization
plan. We held on familiar principles in connection with reorganizations for
tax purposes that he could not "atomize a plan."

29

I turn to cited cases decided in other circuits: In Commissioner of Internal

Revenue v. The Hub, 4 Cir., 68 F.2d 349, 350, the taxpayer, a Wheeling, West
Virginia, clothier, joined with other Wheeling retailers in organizing the Ohio
Valley Industrial Corporation. The purpose of the corporation was to arrest the
economic decline then experienced in Wheeling, by planning for and assisting
in the settlement of new industry in the Wheeling area. Taxpayer's subscriptions
to the capital of the corporation were permitted to be deducted as a business
expense. In that case, however, the stock of the corporation, as distinguished
from the government bonds in the instant case or from the Fair bonds in
Exposition Souvenir, could not be regarded as an investment. The Ohio Valley
Industrial Corporation was a nonprofit corporation, exempt from state and local
taxes. The certificate of incorporation, after declaring that "`This Corporation is
not organized for personal gain, but only as a civic-undertaking,'" specifically
provided that "`there shall never be any dividends declared from profits, and all
profits accruing shall be placed in a surplus fund for the objects and purposes of
the Corporation.'" In those unusual circumstances, the court did not consider
the stock purchase a purchase of capital assets.

30

In Edwards v. Hogg, 5 Cir., 214 F.2d 640,2 the taxpayer, engaged in the
business of selling liquor, purchased all the shares of stock of a distilling
company for the sole purpose of obtaining the liquor owned by the distilling
company, and which the taxpayer intended to sell to its own customers in the
ordinary course of its business. Looking through the distilling company to its
assets, it was apparent that the purchase of that company's stock was but a
means of acquiring the liquor which was then in short supply, i. e., obtaining
the liquor was taxpayer's essential purpose. The liquor itself was property of a
kind which came within one of the exceptions explicitly stated in Section
117(a) (1).3 Gilbert v. Commissioner, 1 Cir., 56 F.2d 361, presents a case where
a building contractor received, as compensation, shares of stock in the company
for which the building was erected. As found by the trial court, he accepted

them in lieu of cash and intended to convert them into cash as soon as possible
(a practice not uncommon among engineering and contracting firms of that
day). The court found that, in those circumstances, the stock was property held
by the taxpayer primarily for sale in the course of his trade or business. I think
a better rationale of that decision would be that, whenever a taxpayer receives
property as compensation, the situation is to be regarded as if he had received
cash and had then invested it in that property; the cash value of the property is
therefore part of his ordinary gross income and taxable as such. Section 117 has
no application to a case of that sort. If, however, such a taxpayer retains the
property, then it is a "capital asset" i. e., an investment in that property
and Section 117 applies to its subsequent disposition.
31

There is no need to consider here the problem which would arise if a taxpayer,
as part of a contract, obligated himself to buy some securities, from the other
party to the contract, at a price above the market price. For that was not the case
here. Indeed, the contract here did not require taxpayer to buy any government
bonds but merely to put such bonds in escrow, a requirement which could have
been met without a purchase of bonds, if the taxpayer had already owned a
sufficient amount of them.

32

My conclusion here derives from no ardent desire to add to the government's

revenues by invariably interpreting statutes adverse to taxpayers; see, e. g., my
dissenting opinion in Babcock & Wilcox Co. v. Pedrick, 2 Cir., 212 F.2d 645.
But I think that courts should not allow what they deem fairness to taxpayers to
over-ride one of the most sensible canons of statutory construction, i. e., that,
where a statute sets forth specific exceptions, further exceptions, by way of
mere implication, are not permissible.4 Moreover, to hold for the taxpayer here
may well mean unfairness to other taxpayers who, having acquired securities in
situations just like this, but having made a gain on the sale of the securities,
seek to claim that their taxable profits are capital gains, not ordinary income.

Notes:
1

Of course, this rule of interpretation may yield where (1) if applied the statute
would approach the absurd or (2) the legislative history clearly shows a
different legislative purpose

The court, on the issue relevant here, adopted the conclusions of the district
court, reported in Hogg v. Allen, 105 F. Supp. 12, 21

See Western Wine & Liquor Co., 18 T. C. 1090, 1099; Charles A. Clark, 19

T.C. 48, 51
4

See cases cited supra