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European American Bank & Trust Co. v. United States

Decided: July 23, 1991.


Appeal from the United States Claims Court.

Newman, Mayer, and Lourie, Circuit Judges. Newman, Circuit Judge, dissenting.



European American Bank & Trust Company, European American Banking Corporation, and European American Bank-Corp (collectively "EAB") appeal the June 19, 1990, judgment of the United States Claims Court, allowing the United States' motion for partial summary judgment and dismissing that portion of EAB's complaint seeking a tax refund. The taxes were imposed on accrued interest on loans for which EAB had previously taken bad debt deductions. See European American Bank and Trust Co. v. United States, 20 Cl. Ct. 594 (1990). We affirm.


We review the grant of summary judgment by the Claims Court de novo. Turner v. United States, 901 F.2d 1093, 1095 (Fed. Cir. 1990). The issues addressed by the Claims Court -- whether there was a reasonable expectancy of receiving both principal and interest on the Birds loans, the value of the security, and whether other sources of payment were available -- were not raised in the motion for summary judgment or otherwise before the court, and EAB was denied the opportunity to present its case on these issues. However, the parties agreed that the issues raised in the government's motion were fully briefed by both sides and that disposition on those issues was appropriate. In view of this posture of the case, we decide this appeal on the basis of the motion made by the government and briefed by the parties about which the parties agreed there were no genuine issues of material fact.

The issues raised in the government's motion were: (1) whether EAB should be permitted to first apply loan payments received or expected to principal, and thus avoid tax on its interest income; and (2) whether EAB had a reasonable expectancy that the interest income would be paid, without considering whether principal on the loan would be paid.

The terms of the loan documents provided that the payments were to be first applied to the payment of interest accrued and unpaid, then to items not relevant to this dispute, and thereafter to principal. [A140] The only time the payments could be applied in a different order was "after the Note has been declared due and payable," after which payments could be applied "in the sole interest of the holder of the Note, without regard to the effect such action may have upon the rights of any other person under the assignment . . . ." [A141] Under the agreement, the holder may declare the notes due and payable, inter alia, upon the insolvency of the Birds companies. Although EAB argues that the Birds companies were insolvent in January 1976, when the estimated value of the reserves was reduced, at no time did EAB declare the notes due and payable. Failure to declare the loan in default precludes EAB from deviating from the contract requirement that payments be allocated to interest first. Such declaration puts the payor on notice that interest deductions on future payments are no longer available. In any event, whatever the reason for the contract provision, it is controlling.

EAB argues that, regardless of the provisions of the loan documents, the cash payments it received may not be applied first to interest because "there can be no income so long as there is significant doubt that principal will be recovered." We disagree.

The law is clear that a taxpayer who has entered into a contract that characterizes payments made thereunder in a certain way is not free to disregard the contract's terms and adopt a different characterization having more favorable tax consequences. See Proulx v. United States, 594 F.2d 832, 839-40 (Ct. Cl. 1974); Commissioner v. Danielson, 378 F.2d 771, 775 (3d Cir.), cert. denied, 389 U.S. 858 (1967) (en banc). Whether the principal on the loan was likely to be paid is not relevant to the issues before us. At no time was EAB entitled under the loan documents to treat the cash payments as anything other than interest first, unless the loan was in default. It may not now modify the terms of that contract; such a result would nullify the reasonably predictable tax consequences of the agreement between the parties to the loan contract. Since payors appear to have deducted these payments, permitting EAB to avoid their accrual as income might provide them with an unexpected and unjustified windfall to the detriment of the treasury.

EAB cites authority for the proposition that where there is no reasonable expectation of recouping a loan, income recognition is not required. However, in none of the cases cited was there a contractual provision, as here, that required treatment of payments first as interest.

The interest due for the years in question amounted to approximately $6.8 million, while the cash actually received by EAB amounted to $6.3 million. [1050] The value of the reserves ranged between $11.76 and $16.97 million during these years. [1050] Thus, the cash actually received by EAB was only $500,000 less than the total amount of interest that was due on the loans, and the value of the collateral securing the loans was at least $11 million during this period. In these circumstances, there was a reasonable expectancy that the interest would be paid. Accordingly, we affirm the Claims Court's judgment.

NEWMAN, Circuit Judge, dissenting.

I respectfully dissent, for the panel majority has not reached a ...

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