## Facts

- Charles H. Davison and two others formed White Tail, an Illinois general partnership, to operate large-scale farming operations in North Carolina; Davison held a one-third partnership interest.
- White Tail and the Davisons were calendar-year, cash-method taxpayers.
- John Hancock Mutual Life Insurance Company extended mortgage loan commitments to White Tail, including a 1980 commitment allowing advances up to a stated maximum principal amount.
- White Tail owed John Hancock a principal-and-interest installment due January 1, 1981, but lacked funds to make the payment.
- John Hancock advanced $1,587,310.46 to White Tail on December 30, 1980, for the purpose of enabling White Tail to satisfy the upcoming installment’s interest component owed to John Hancock.
- White Tail deposited the advance into its checking account and, on December 31, 1980, wired John Hancock the full installment amount (principal and interest).
- White Tail claimed the interest portion as an interest expense for 1980, and the Davisons claimed their distributive share of that interest deduction on their 1980 return.
- The IRS disallowed the deduction on the ground that using funds borrowed from the same lender, advanced to fund the interest payment to that lender, did not constitute “interest paid” for purposes of I.R.C. § 163(a).

## Issues

1. Whether a cash-basis partnership “paid” interest within the taxable year under I.R.C. § 163(a) when it used funds borrowed from the same lender, advanced specifically to fund the interest installment, to remit an interest payment to that lender.

## Decision

- The Tax Court sustained the Commissioner’s disallowance of the Davisons’ distributive-share interest deduction for 1980.
- The court held that the transaction did not result in deductible “interest paid” under § 163(a) because its economic effect was to postpone the interest obligation rather than discharge it.
- The court treated the advance-and-remittance steps as an integrated arrangement in which the lender effectively financed its own interest receipt.
- The Tax Court’s judgment was affirmed on appeal by the United States Court of Appeals for the Second Circuit for substantially the same reasons.

## Legal Principles

- Under I.R.C. § 163(a), a cash-basis taxpayer may deduct interest only when it is actually paid; a purported payment that does not discharge the obligation in economic terms is not “paid” for this purpose.
- Substance-over-form controls where a circular borrowing arrangement from the same lender is structured to fund an immediate interest remittance back to that lender.
- When borrowed funds are advanced for the express purpose of paying interest to the same lender and are effectively earmarked to that obligation, the remittance is treated as a deferral or capitalization of interest, not a deductible payment.
- Prior precedent suggesting deductibility based on temporary control over borrowed funds does not govern where the integrated transaction’s economic effect is merely to roll interest into continuing indebtedness.

## Conclusion

The Tax Court held that White Tail’s year-end remittance of interest to John Hancock, funded by a contemporaneous advance from John Hancock made to enable that remittance, did not constitute “interest paid” under § 163(a) for a cash-basis taxpayer because the arrangement only postponed the interest obligation rather than satisfying it.


Davison v. Commissioner, 107 T.C. 35 (1996)