The opinion
Simpson, J., dissenting in part: In my judgment, the majority’s conclusion with respect to the second issue violates fundamental principles of the tax law and is not required by the decisions of this or other courts. Because it used the accrual method of accounting, Putoma was allowed to deduct the interest payments when it became obligated to make them, and such deductions reduced its tax liability. Even though it never made such payments and the obligation to make them was ultimately extinguished, the majority’s conclusion would allow Putoma to retain such tax benefit.
The objective of tax accounting is to compute, on an annual basis, the net amount of a taxpayer’s income which should be subject to tax — that is, the excess of his income over the expenses properly chargeable to the production of such income within the annual accounting period. See sec. 441; Burnet v. Sanford & Brooks Co., 282 U.S. 359, 363, 365-366 (1931). Such income may be computed by use of the accrual method of accounting. Sec. 446. When that method is used, income must be reported for the period during which the right to the income becomes fixed and its amount is determinable in the light of the circumstances existing during the taxable year (sec. 451; sec. 1.451-(a), Income Tax Regs.), and deductions are allowable for those items which become liabilities during such taxable year, even though payment is not made until some subsequent period (sec. 461; sec. 1.461-l(a)(2), Income Tax Regs.). The deduction is allowed on the assumption that the liability will eventually be paid. However, if, subsequently, the obligation to make the payment is modified, the taxpayer has received a tax benefit, to which, in the light of subsequent events, he was not entitled.
A similar situation arises when a cash method taxpayer deducts a payment actually made and when such payment is subsequently recovered in whole or in part, and the courts have long held that in such situations, the recovery must be reflected in income. In Burnet v. Sanford & Brooks Co., supra, the taxpayer sustained losses on a contract in one year and recovered the losses in a later year, and it was held that the recoveries must be included in income in the year recovered. Cooper v. United States, 9 F.2d 216 (8th Cir. 1925), held that the recovery of a fire loss previously deducted must be included in income in the year of recovery. Askin & Marine Co. v. Commissioner, 66 F.2d 776 (2d Cir. 1933), affg. 26 B.T.A. 409 (1932), held that the recovery of a debt previously deducted was includable in income in the year recovered. See also Maryland Casualty Co. v. United States, 251 U.S. 342 (1920); Carr v. Commissioner, 28 F.2d 551 (5th Cir. 1928), affg. 6 B.T.A. 541 (1927); Davidson Grocery Co. v. Lucas, 37 F.2d 806 (D.C. Cir. 1930), revg. 12 B.T.A. 181 (1928); Putnam National Bank v. Commissioner, 50 F.2d 158 (5th Cir. 1931), affg. 20 B.T.A. 45 (1930); Commissioner v. Liberty Bank & Trust Co., 59 F.2d 320 (6th Cir. 1932), revg. 14 B.T.A. 1428 (1929); Helvering v. State-Planters Bank & Trust Co., 130 F.2d 44 (4th Cir. 1942), revg. 45 B.T.A. 630 (1941); Houbigant, Inc., 31 B.T.A. 954 (1934), affd. per curiam 80 F.2d 1012 (2d Cir. 1936), cert. denied 298 U.S. 669 (1936). Thus, the principle is well established that when the grounds for a deduction are modified by subsequent events, there must be an adjustment in income to reflect the changed circumstances. 1 In time, the courts held that in making the adjustment, the extent of the tax benefit realized in the earlier year should be taken into consideration, and the rule came to be referred to as the tax benefit rule. Sec. 111; Merchants Nat. Bank of Mobile v. Commissioner, 199 F.2d 657 (5th Cir. 1952), affg. 14 T.C. 1375 (1950); West Seattle National Bank of Seattle v. Commissioner, 288 F.2d 47 (9th Cir. 1961), affg. 33 T.C. 341 (1959); Bear Manufacturing Co. v. United States, 430 F.2d 152 (7th Cir. 1970), cert. denied 400 U.S. 1021 (1971); Mayfair Minerals, Inc. v. Commissioner, 456 F.2d 622 (5th Cir. 1972), affg. per curiam 56 T.C. 82 (1971); Alice Phelan Sullivan Corp. v. United States, 381 F.2d 399 (Ct. Cl. 1967); Motor Products Corp., 47 B.T.A. 983 (1942), affd. per curiam 142 F.2d 449 (6th Cir. 1944).
Recently, the courts have recognized that such principle should be applied even more broadly. For example, the courts have held that even though a statutory provision declared a transaction did not result in taxable income, the statute was not intended to apply when the transaction resulted in a tax benefit to the taxpayer because he recovered an item previously deducted. Connery v. United States, 460 F.2d 1130 (3d Cir. 1972); Spitalny v. United States, 430 F.2d 195 (9th Cir. 1970); Commissioner v. Anders, 414 F.2d 1283 (10th Cir. 1969); Anders v. United States, 462 F.2d 1147 (Ct. Cl. 1972), cert. denied 409 U.S. 1064 (1972); Estate of David B. Munter, 63 T.C. 663 (1975). In like manner, such principle should be applied to the tax benefit received by Putoma as a result of the deduction of the interest obligations which it was not required to make.
In the cases, there has arisen some unfortunate confusion between the tax benefit rule and the rule that income may result from the cancellation of indebtedness. The tax benefit rule is in effect an accounting rule. On the other hand, the cancellation of indebtedness may, in effect, be viewed as a substitute for the transfer of money, property, or other things of value, or it may be viewed as the nongratuitous receipt of the goods or services which underlies the indebtedness — in either event, it may give rise to taxable income. Sec. 1.61-12, Income Tax Regs.; Commissioner v. Jacobson, 336 U.S. 28 (1949); United States v. Kirby Lumber Co., 284 U.S. 1 (1931). The distinction between the two rules may be illustrated by an example: If a taxpayer, who uses the accrual method of accounting, incurs a liability to pay $100 of rent in 1976, the deduction results in a tax saving for him. If the liability for rent is forgiven in 1977, there must be an accounting adjustment. If the cancellation of the liability was gratuitous, the accounting adjustment is the only tax consequence of such cancellation. The taxpayer is then in the same situation as a taxpayer who used the cash method of accounting and who would therefore never have been entitled to the deduction and the tax saving. On the other hand, if the liability was forgiven as a means of paying the debtor for services rendered, the debtor is required to report $100 as income in such year and pay a tax on it. In effect, the debtor has fulfilled his obligation to pay rent for the preceding year, and the creditor has handed that money back to him as payment for services rendered. Although the debtor is required to pay an additional tax in 1977 in both situations, that result comes about for different reasons.
In the cases relied upon by the majority, the question for decision was whether the cancellation was gratuitous. Those cases did not focus on whether there should be an accounting adjustment as a result of a prior deduction, and they should not control our decision in this case. In Commissioner v. Auto Strop Safety Razor Co., 74 F.2d 226 (2d Cir. 1934), and Carroll-McCreary Co. v. Commissioner, 124 F.2d 303 (2d Cir. 1941), the courts were merely asked to find whether the cancellation of the indebtedness was gratuitous, and the income tax regulations then in effect expressly provided that if the cancellation was gratuitous, it resulted in no cancellation of indebtedness income. Likewise, in Helvering v. American Dental Co., 318 U.S. 322 (1943), the Supreme Court’s concern was with whether the cancellation was gratuitous, and since it found the act to be gratuitous, it held that such transaction did not result in cancellation of indebtedness income. Although the Court recognized that the indebtedness had been previously deducted, the Court recited that the only issue presented by its grant of certiorari was whether income resulted from the cancellation of rent and interest which were owed by the taxpayer. Thus, the Court was dealing with the principle of whether income results from the cancellation of such obligations, irrespective of whether the debtor used the accrual method of accounting and had already deducted such rent or interest, and the Court did not focus on whether an accounting adjustment should be made upon the forgiveness of items which had been previously deducted. Furthermore, shortly thereafter, when the Supreme Court was considering the applicability of the tax benefit rule in Dobson v. Commissioner, 320 U.S. 489 , 506 n. 36 (1943), the Court appeared to assume that such rule is applicable with respect to the “cancellation of expenses or interest previously reported as accrued.” The cases that have been decided since American Dental also do not expressly pass on the necessity of an accounting adjustment if the indebtedness canceled had been previously deducted and had given rise to a tax benefit; they only deal with the issue of whether cancellation of indebtedness income was realized. Reynolds v. Boos, 188 F.2d 322 (8th Cir. 1951); Hartland Associates, 54 T.C. 1580 (1970); Utilities & Industries Corp., 41 T.C. 888 (1964), revd. on other grounds sub nom. The South Bay Corp. v. Commissioner, 345 F.2d 698 (2d Cir. 1965).
This Court deals exclusively in matters concerning Federal taxes, and we are expected to have expertise in such matters. 2 As such, we have a special obligation to understand and apply properly the principles of the tax law. Everyone recognizes that because of the tax benefit realized by Putoma as a result of the prior deduction of the interest obligations, there should be an accounting adjustment when the corporation is released from its obligation to make such payments, and we, as the experts in such matters, should attempt to clarify this area of the law and not add to its confusion by extending doctrines to situations where they should not be applied. Moreover, if we abrogate our responsibility and pass up this opportunity to clarify the law, we invite, nay require, legislative action. Everyone deplores the complexity of the Federal tax laws, and here we have an opportunity to avoid making it more complex. If we fail to clarify the applicability of the tax benefit rule and the rule relating to income from the cancellation of indebtedness, it will become necessary for Congress to amend the statutes and add further conditions and restrictions to them.
Raum and Sterrett, JJ., agree with this dissent. If both the payor and payee used the accrual method of accounting, and the payee reported the right to the payment as income, these circumstances may alter the necessity of making an accounting adjustment when the liability is subsequently modified. O’Hare, “Statutory Nonrecognition of Income and the Overriding Principle of the Tax Benefit Rule in the Taxation of Corporations and Shareholders,” 27 Tax L. Rev. 215 ,240-244 (1972).
Such a view was articulated by Mr. Justice Stewart at the dedication of the Tax Court building when he said:
“It is true that the Supreme Court does not review many tax cases, but I think the real reason for this is not the complexity of the cases, but rather a basic confidence in the experienced ability and perceptive understanding of the United States Tax Court. It is significant that both the very first and the very most recent of our Court’s decisions involving cases originating in the Tax Court constituted affirmances of the Tax Court’s judgments. The earliest case, a 1927 decision, was Blair v. Oesterlein Machine Co. This was a landmark decision involving the very judicial credentials of the Board of Tax Appeals, as it was then called. The Supreme Court in that case rejected an attempt by the Commissioner to limit the jurisdiction and powers of the Board. The Supreme Court’s most recent review of a Tax Court decision was in the case of Commissioner v. Idaho Power Co., this year, in which our Court’s opinion upholding the Tax Court was written by Mr. Justice Blackmun, who is here today.
“The Supreme Court has always had great respect for the competence and independence of the Tax Court. In fact, in the Dobson case in 1943, the Supreme Court, speaking through Mr. Justice Jackson, adopted a rule precluding appellate review of Tax Court determinations in the absence of exceptional or extraordinary circumstances. That rule lasted for only 5 years. It was changed by Congress in 1948.
“But good ideas die hard, and some Justices never fully accepted the wisdom of the Congressional verdict on the Dobson case. In the later Arrowsmith case, Mr. Justice Jackson again paid a meaningful tribute to the Tax Court, and I quote: “In spite of the gelding of Dobson ... I still think the Tax Court is a more competent and steady influence toward a systematic body of tax law than our sporadic omnipotence in a field beset with invisible boomerangs.” That time, of course, Mr. Justice Jackson’s thoughts were expressed in a dissenting opinion.
“Appropriate judicial restraint prevents me from taking this occasion to bemoan the passing of the doctrine of the Dobson case, Nevertheless, the spirit behind that decision — a respect for the ability and integrity of the United States Tax Court — is one in which I know all the members of our Court fully concur. * * * [63 T.C. XVII-XVIII (1974).]”