ALVIN B. RUBIN, Circuit Judge:
We here consider the deductibility of interest paid by a cash basis taxpayer with money borrowed to fulfill his interest obligations on loans made in participation by a group of banks. The taxpayer borrowed from the lead bank to pay interest due both that bank and the other banks that had participated in loans to him. All parties agree that the portion of the interest payments attributable to the lead bank's share in the loans is not deductible. Reversing the tax court, we conclude that the portion of the interest payments attributable to the shares of the participating banks in the prior loans is deductible.
H. C. Franklin was chief executive officer of Lone Star Company in Dallas, Texas. He and his first wife, Camille, were divorced in March 1972. In order to complete a community property settlement, Franklin borrowed $2,250,000 (the "1973 loan") in a transaction arranged by Capital National Bank in Austin ("Capital Bank"). Capital Bank did not, however, make the loan entirely for its own account. While Franklin signed a note payable to Capital Bank, the note referred to "this note ... or participation therein." Capital Bank in fact sold loan participations and issued certificates of participation in the note to five other Texas banks. Capital Bank as the manager of the loan, or the lead bank, retained a $530,000 share (about 23.5%) in the note.
When the $2,250,000 note matured in March 1973, Franklin borrowed $120,124.99 from Capital Bank (the "1973 interest note"). This loan, made by Capital Bank alone, was used to pay the unpaid interest then owing on the 1973 loan. The interest was actually disbursed to the participating banks in accordance with their rights under the certificates of participation.
Franklin renewed the 1973 loan, but this time nine banks participated in the loan (the "1974 loan"). Capital Bank retained $530,000 of the 1974 loan. When the 1974 loan fell due in March 1974, the unpaid interest on it amounted to $206,414.49. Capital Bank, acting alone, loaned Franklin $217,491.27 (the "1974 interest note"). $188,865.99 represented unpaid interest due the participating banks on the second loan, $17,548.50 represented unpaid interest due to Capital Bank on the 1974 loan, and the remainder, $11,076.78, represented unpaid interest due Capital Bank on the 1973 interest
The Commissioner filed a notice of deficiency asserting that Franklin was not entitled to interest deductions of $120,124.99 and $217,491.00 for the years 1973 and 1974, respectively. Franklin petitioned the Tax Court for a redetermination of the deficiency. The Tax Court held that Franklin was not entitled to the interest deductions because he had not actually paid the interest due, but, by borrowing to meet his interest obligations, he had merely given Capital Bank a promise to pay the interest in the future. The Tax Court rejected Franklin's alternative argument that, if the interest deductions were denied, he should be allowed to use the accrual method of accounting to reflect the interest charges.
Section 163(a) of the Internal Revenue Code allows as a deduction from income "all interest paid or accrued within the taxable year on indebtedness." (Emphasis added.) Interest paid to one lender by a cash basis taxpayer with funds borrowed from a second lender is deductible when the interest is paid.
In Battelstein, supra, when the interest due the taxpayers' creditor came due, the taxpayers executed a separate interest note with the creditor. The money advanced by the creditor was deposited in a bank account, and the taxpayers drew a check on this account to "pay" the interest owing to the creditor. Nothing more than "paper-shuffling" was involved. The taxpayers-debtors might never have paid the new note, and the creditor might never have actually received payment of the interest owed. That interest was in effect merely renewed and rolled over, and the court held that "such a surrender of notes does not constitute payment for tax purposes entitling a taxpayer to a deduction." 631 F.2d at 1184. We distinguished this situation from
631 F.2d at 1184 n.3.
Franklin here did not engage in mere "paper-shuffling." While the amounts paid Capital Bank as interest on the 1973 and 1974 loans were merely roll-overs or changes in the form and maturity or the interest obligation then owing to Capital Bank, actual disbursements of the interest payments due the participating banks were made to those banks each year. Each participant was paid its share of the interest, subject to no future contingencies so far as those banks were concerned.
"The proper legal characterization of [participation agreements] is a topic about which increasing controversy exists."
It is not significant that the participants were not named in the notes or that Franklin was not a party to the participations.
On appeal, Franklin concedes that he is not entitled to deduct the portion of the interest payments on the two interest notes attributable to Capital Bank's participation in the loans. Accordingly, since we find that Franklin is entitled to deduct the interest payments attributable to the participations of the other banks, it is unnecessary to reach Franklin's alternative argument that, if denied the interest deductions, the Commissioner should allow Franklin to account for the loans via accrual accounting.
For these reasons, the judgment of the Tax Court is REVERSED. The case is REMANDED for further proceedings consistent with this opinion to redetermine the allowable interest deductions for 1973 and 1974.
In March 1975, Franklin obtained a $2,850,000 loan from Mercantile National Bank at Dallas and used the proceeds to pay the 1974 loan, the 1973 and 1974 interest notes, and accrued interest thereon.
Comment, supra note 3, at 285 n.74.
The lead-participant relationship has been characterized in a variety of ways. For instance, Hutchins, supra note 6, at 458-74 describes six possible relationships: debtor-creditor, assignment, tenancy in common, joint venture, agency, and trust. Under the terms of the participation agreement in this case, however, the participant is an assignee of a percentage interest of the loan and the lead bank is the agent for servicing the entire loan. See, MacDonald, supra, at 39 n.12 ("in bank and savings and loan liquidations run by the FDIC and FSLIC, sales of participations are typically honored as the transfer of an ownership interest in the underlying loan"). Several cases have also recognized this characterization of the lead-participant relationship. See FDIC v. Mademoiselle of Cal., 379 F.2d 660, 665 (9th Cir. 1967) (if the debtor had made a specific payment on the note to the insolvent lead rather than setting off its deposit in an account with the lead against the note, then this case would come within the rule that assignment of 80% of the note to a participant would pass legal title in 80% of the proceeds to the participant); Delatour v. Prudence Realization Corp., 167 F.2d 621, 624 (2d Cir. 1948) (certificate holders were "owners of the mortgage" and after default by the mortgagor and creditor were entitled to an "aliquot share of the principal of the fruits of that share represented by the interest reserved in the mortgage"); In re Fried Furniture Corp., 293 F.Supp. 92 (E.D.N.Y.1968) (SBA, as a 75% participant in a loan, has a lien on the proceeds of the sale of the bankrupt's chattel), aff'd mem., 407 F.2d 360 (2d Cir. 1969). But see In re Alda Commercial Corp., 327 F.Supp. 1315 (S.D.N.Y.1971); Drake & Weems, supra note 6 (the authors conclude that a trustee in bankruptcy can reduce the claims of participants to the status of unsecured creditors).