APPEAL FROM THE UNITED STATES DISTRICT COURT FOR THE EASTERN DISTRICT OF PENNSYLVANIA (D.C. Civil Action No. 69-2791).
Seitz, Chief Judge, Van Dusen and Weis, Circuit Judges.
VAN DUSEN, Circuit Judge.
The question in this case is whether payments made on two series*fn1 of obligations (denominated "debentures") of Scriptomatic, Inc. (plaintiff) were deductible as interest under 26 U.S.C. § 163, or were, in reality, disguised dividends and therefore not deductible by the corporation. On June 24, 1975, the district court entered judgment for plaintiff notwithstanding a December 1973 jury verdict answering special questions in favor of defendant,*fn2 see Scriptomatic Inc. v. United States, 397 F. Supp. 753 (E.D. Pa. 1975), from which the government appeals.*fn3 The judgment n.o.v. having been properly entered, we affirm the district court order.
In Fin Hay Realty Co. v. United States, 398 F.2d 694 (3d Cir. 1968), this Court enumerated sixteen criteria which as we stated there, have been isolated by the courts and commentators as factors which have been used in evaluating "the nature of an instrument which is in form a debt." 398 F.2d at 696. However, those criteria were never intended to obtain talismanic significance. The essence of Fin Hay is contained in the following quotation from it:
"Neither any single criterion nor any series of criteria can provide a conclusive answer in the kaleidoscopic circumstances which individual cases present.
"The various factors which have been identified in the cases are only aids in answering the ultimate question whether the investment, analyzed in terms of its economic reality, constitutes risk capital entirely subject to the fortunes of the corporate venture or represents a strict debtor-creditor relationship. Since there is often an element of risk in a loan, just as there is an element of risk in an equity interest, the conflicting elements do not end at a clear line in all cases.
"In a corporation which has numerous shareholders with varying interests, the arm's-length relationship between the corporation and a shareholder who supplies funds to it inevitably results in a transaction whose form mirrors its substance. Where the corporation is closely held, however, and the same persons occupy both sides of the bargaining table, form does not necessarily correspond to the intrinsic economic nature of the transaction, for the parties may mold it at their will with no countervailing pull. This is particularly so where a shareholder can have the funds he advances to a corporation treated as corporate obligations instead of contributions to capital without affecting his proportionate equity interest. Labels, which are perhaps the best expression of the subjective intention of parties to a transaction, thus lose their meaningfulness.
"To seek economic reality in objective terms of course disregards the personal interest which a shareholder may have in the welfare of the corporation in which he is a dominant force. But an objective standard is one imposed by the very fact of his dominant position and is much fairer than one which would presumptively construe all such transactions against the shareholder's interest. Under an objective test of economic reality it is useful to compare the form which a similar transaction would have taken had it been between the corporation and an outside lender, and if the shareholder's advance is far more speculative than what an outsider would make, it is obviously a loan in name only." [Footnote omitted. Emphasis added.]
Under Fin Hay, then, the ultimate issue is measurement of the transaction by objective tests of economic reality, and the touchstone of economic reality is whether the transaction would have taken the same form had it been between the corporation and an outside lender - whether, in sum, "the shareholder's advance is far more speculative than what an outsider would make." The analysis suggested by this approach to the debt-equity question may be expressed in terms of two lines of inquiry: assuming that the obligation is debt in form,*fn4 (1) did the form result from an arm's-length relationship, and/or (2) would an outside investor have advanced funds on terms similar to those agreed to by the shareholder.*fn5
If question one is answered in the affirmative (the form did result from arm's-length dealings), the obligation is debt. If question two is answered in the affirmative (an outsider would have advanced funds on terms similar to those agreed to by the shareholder), the obligation is debt - despite the fact that the negotiations leading to its issuance were not at arm's length. As is apparent, if there is proof or agreement that an outsider would have purchased an instrument on the terms available to a shareholder, the question as to whether the form of the obligation resulted from arm's-length negotiation is irrelevant to resolution of the debt-equity issue. The crucial issue is the economic reality of the marketplace: what the market would accept as debt is debt.
It is only within this framework that the many factors listed in Fin Hay and in other court decisions in this area have any meaning or function. One or more of those factors may be relevant to the threshold question of whether the instrument is debt in form. One or more of those criteria may, in the same sense, be helpful in evaluating whether there was an arm's-length relationship. Certain of those elements may also bear on the fundamental inquiry, whether an obligation is commercially valuable as an obligation and, therefore, debt in "economic reality." However, the criteria which will be relevant to each of those three areas of inquiry will vary from case to case, as will the weight which should be accorded each criterion. For this reason, two court decisions in this area will rarely present comparable situations and it will be unusual for any particular case to have controlling effect in any other case on the basis of the ...