Petition — Boise Cascade Corp. v. United States

i JUN 23 1976

, aR., CLERK

IN THE

Supreme Court of the Uuited States

October Term, 1975

Ne 75-1853

Boise CascapE CorPoRATION AND Supsipiary CoMPANIEs,

Petitioner,

V.

-Tue Unirep States

Petition for a Writ of Certiorari to the

United States Court of Claims

Frank Norton Kern

LAWRENCE CHAseE WILSON

Counsel for Petitioner

Reid & Priest

40 Wall Street

New York, New York 10005

June 1976

IN THE

Supreme Court of the United States

October Term, 1975

No.

ae

Boise CascapE CorPORATION AND SussipIARY COMPANIES,

Petitioner,

v.

THe Unitep STaTes

Petition for a Writ of Certiorari to the

United States Court of Claims

Boise Cascade Corporation and Subsidiary Companies,

by their attorneys, petitions for a writ of certiorari to

review the judgment of the United States Court of Claims.

Opinions Below

The findings of fact and opinion of the Trial Judge of the

United States Court of Claims (which insofar as relevant

to the issue with respect to which a writ of certiorari is

sought are reprinted in Appendix A, infra, pp. A-1 through

A-21) are not officially reported. The opinion of the Court

of Claims (which insofar as relevant to the issue with

respect to which a writ of certiorari is sought) is reprinted

in Appendix B, infra, pp. B-1 through B-3. The order of

the Court of Claims amending the opinion is reprinted in

Appendix C, infra, p. C-1. The opinion of the Court of

Claims in General Foods Corporation v. United States,

Court of Claims no. 70-73 (Appendix D, infra, pp. D-1

through D-14) is not officially reported, and a copy is

attached in view of the Court of Claims’ reliance on this

decision in their opinion in the instant case.

Jurisdiction

The judgment of the Court of Claims (Appendix B,

infra, p. B-3) was entered on January 28, 1976. The juris-

diction of this Court is invoked under 28 U.S.C. 1255(1).

Question Presented

Whether gains attributable to original issue discount on

evidences of indebtedness, issued by corporations after

December 31, 1954 and before May 28, 1969, and held by

plaintiffs for periods of not more than six months are tax-

able as short-term capital gains in the year such evidences

of indebtedness were sold or exchanged.

Statutes Involved

Section 1232, as originally enacted in the Internal Reve-

nue Code of 1954, P.L. 591, 68A Stat. 3 provides in part as

follows:

“Sec. 1232. Bonps anp Orner Evipences or INDEBTED-

NESS.

(a) GeneraL RuLe.—For purposes of this subtitle,

in the case of bonds, debentures, notes, or certificates

or other evidences of indebtedness, which are capital

assets in the hands of the taxpayer, and which are

issued by any corporation, or government or political

subdivision thereof—

(1) Retrrement.—Amounts received by the

holder on retirement of such bonds or other evi-

3

dences of indebtedness shall be considered as

amounts received in exchange therefor (except that

in the case of bonds or other evidences of indebted-

ness issued before January 1, 1955, this paragraph

shall apply only to those issued with interest cou-

pons or in registered form, or io those in such

form on March 1, 1954).

“(2) Sate or ExcHaNnce.—

(A) Genera Rute.—Except as provided in

subparagraph (B), upon sale or exchange of

bonds or other evidences of indebtedness issued

affer December 31, 1954, held by the taxpayer

more than 6 months, any gain realized which

does not exceed an amount which bears the same

ratio to the original issue discount (as defined

in subsection (b)) as the number of complete

months that the bond or other evidences of in-

debtedness was held by the taxpayer bears to

the number of complete months from the date

of original issue to the date of maturity, shall he

considered as gain from the sale or exchange of

property, which is not a capital asset. Gain in

excess of such amount shall be considered gain

from the sale or exchange of a capital asset held

more than 6 months.

“(b) Derrnitions.—

(1) Orternat Issuz Discount.—For purposes

of subsection (a), the term ‘original issue dis-

count’ means the difference between the issue

price and the stated redemption price at matur-

ity. If the original issue discount is less than

one-fourth of 1 percent of the redemption price

at maturity multiplied by the number of com-

plete years to maturity, then the issue discount

shall be considered to be zero. For purposes of

this paragraph, the term ‘stated redemption

4

price at maturity’ means the amount fixed by

the last modification of the purchase agreement

and inclué dividends payable at that time.”

Section 1232, as amended by the Tax Reform Act of

1969, P. L. 91-172, 83 Stat. 487 provides in pertinent part

as follows:

“Sec. 1232. Bonds and Other Evidence of Indebted-

ness.

° e * e

“(B) CorPoRATE BONDS ISSUED ON OR BEFORE MAY 27,

1969, AND GOVERNMENT BONDS.—Except as provided in

subparagraph (C), on the sale or exchange of bonds

or other evidences of indebtedness issued by a gov-

ernment or political subdivision thereof after

December 31, 1954, or by a corporation after Decem-

ber 31, 1954, and on or before May 27, 1969, held

by the taxpayer more than 6 months, any gain

realized which does not exceed—

(i) an amount equal to the original issue dis-

count (as defined in subsection (b)), or

‘ii) if at the time of original issue there was no

intention to call the bond or other evidence of

indebtedness before maturity, an amount which

bears the same ratio to the original issve discount

(as defined in subsection (b)) as the io»mber of

complete months that the bond or other ‘dence

of indebtedness was held by the taxpayer «urs to

the number of complete months from the date of

original issue to the date of maturity, shall be con-

sidered as gain from the sale or exchange of

property which is not a capital asset. Gain in

excess of such amount shall be considered gain

from the sale or exchange of a capital asset held

more than 6 months.”

Statement

Petitioner’s predecessor by merger purchased noninter-

est bearing evidences of indebtedness at a discount which

were sold or retired in a period of not more than six

months. The evidences of indebtedness were held by the

taxpayer as an investment. Such evidences of indebtedness

were issued by corporations after December 31, 1954 and

before May 28, 1969. The applicable statute is section 1232

of the Internal Revenue Code of 1954 as originally enacted,

the pertinent provisions of which are quoted above.

Effective with respect to evidences of indebtedness issued

after May 27, 1969, section 1232 was amended to change

the law as to evidences of indebtedness issued by corpora-

tions but not as to evidences of indebtedness issued by a

government or a political subdivision thereof.

The gains realized by taxpayer on the sale of evidences

of indebtedness were attributable to original issue dis-

count. Taxpayer treated such gains as short-term capital

gains against which taxpayer offset capital losses or capital

loss carryovers.

The Commissioner of Internal Revenue determined that

the gains should be treated as ordinary income and accrued

ratably as interest is accrued. Deficiencies were assessed

and paid and the taxpayer brought suit for refund in the

United States Court of Claims. The Trial Judge held for

the taxpayer and his decision was reversed by the Court.

In reversing on this issue the Court relied on its decision in

General Foods Corporation v. The United States, both cases

being decided on January 28, 1976.

Reasons for Granting the Writ

The Court of Claims has decided a question of major

significance to the administration of the Internal Revenue

6

Code in a manner which conflicts directly with an express

statement of the Committee on Finance as to the intention

of Congress which statement is exactly on point. The issue

before the Court of Claims concerned the intention of Con-

gress in limiting the application of the provisions of sec-

tion 1232 concerning original issue discount to evidences

of indebtedness “held more than 6 months”; see section

1232(a)(2)(A) quoted above.

When Congress adopted section 1232 as part of the Inter-

nal Revenue Code of 1954 it did not provide that original

issue discount realized by a holder of an evidence of indebt-

edness should be treated like interest but instead estab-

lished a statutory system for treatment of realized original

issne discount. That such a system was established has

been recognized by the Supreme Court of the United States

in Commissioner of Internal Revenue v. National Alfalfa

Dehydrating & Milling Co., 417 U.S. 134 (1974) in footnote

9 of its opinion (417 U.S. 134, 145).

In the system adopted by Congress, it was provided in

section 1232 that gain from the disposal of evidences of

indebtedness “held more than 6 months” shall be treated

as gain from sale of property that is not a capital asset

to the extent that such gain is attributable to original issue

discount. The perio. /f six months is normally the divid-

ing line between short-term and long-term capital gain

under the Internal Revenue Code.

Although there is no express provision in the statute

concerning gain attributable to original issue discount on

evidences of indebtedness held for not more than six

months, Congress indicated that it was its intention that

such gain should be treated as short-term capital gain.

When the Internal Revenue Code of 1954 was originally

adopted, both the Committee on Ways & Means and the

Committee on Finance in their committee reports indicated

7

that gain on the disposal of evidences of indebtedness

would be treated as capital gain except to the extent that

ordinary income treatment was expressly provided. These

statements manifested the intention of Congress in 1954

that original issue discouni on evidences of indebtedness

held for not more than six months shall be treated as short-

term capital gain. The specific statements were as follows:

“Paragraph (1) restates the content of present

law. For bonds or other evidences of indebtedness

issued after December 31, 1954, the bill abandons

present restriction of capital treatment on retire-

ment to bonds and other evidences of indebtedness

which have interest coupons attached or which are

in registered form. Redemption of all bonds and

other evidences of indebtedness will receive capital

gain or loss treatment on redemption if issued after

December 31, 1954, and if they are otherwise capital

assets, except to the extent that the recovery of issue

discount is subject to paragraph (2) [section

1232(a)(2)].” (House Report No. 1337, 83d Cong.,

2d Sess., p. A275 (3 U.S.C. Cong. & Adm. News

(1954) 4017, 4417); Senate Report 1622, 83d Cong.,

2d Sess., p. 433 (3 U.S.C. Cong. & Adm. News (1954)

4621, 5076)) [Emphasis supplied. ]

When Congress amended the Internal Revenue Code of

1954 in the Tax Reform Act of 1969, P.L. 91-172, 83 Stat.

487, the Committee on Finance, reiterating the intention of

Congress previously expressed in 1954, stated directly that

realized original issue discount on evidences of indebted-

ness held not more than six months should be treated as

short-term capital gain. The statement, which was exactly

on point, was as follows:

“The rules provided by the bill regarding the

treatment of original issue discount are not to apply

in the case of bonds or other evidences of indebted-

8

ness issued by any government or political subdivi-

sion (or in the case of bonds or other evidence of

indebtedness issued by a corporation on or before

October 9, 1969). In these cases, the rules of present

law regarding the treatment of original issue dis-

count on the sale or exchange of a bond which is a

capital asset in the hands of the taxpayer and which

has been held by the taxpayer for more than 6 months

are to continue to apply. In addition, in these cases,

gain on the sale or exchange of a bond or other evi-

dence of indebtedness which is a capital asset in the

hands of the taxpayer but which has not been held

by the taxpayer for more than 6 months is to be

treated as a short-term capt‘al gain as under present

law.” (Senate Report Ne. 91-552, 91st Cong., 1st

Sess., 1969-3 C.B. 423, 518) [Emphasis supplied.]

In its report the Committee on Finance not only indi-

cated its understanding and intention that the bonds “held

more than 6 months” in section 1232 had since 1954 required

that realized original issue discount on bonds and other

evidences of indebtedness issued by both corporations and

governments should be taxed as short-term capital gain but

it further indicated that this method of taxation should con-

tinue to apply to bonds and other evidences of indebtedness

issued by a government or political subdivision thereof not

only prior to the effective date of the Tax Reform Act of

1969 but also subsequent to that date and up to the present

time.

In holding that realized original issue discount on evi-

dences of indebtedness held fer not more than six months

should be taxed as ordinary income, the Court of Claims

reached a decision directly contrary to the expressed inten-

tion of Congress concerning a phrase that continues to be

part of section 1232 of the Internal Revenue Code of 1954.

This decision has created confusion on the part of tax-

9

payers as to the correct method of reporting gains from

original issue discount on evidences of indebtedness issued

by government and political subdivisions thereof, whether

domestic or foreign, and has provided a precedent that

administrators of the Internal Revenue Service may con-

sider to require them to tax such gains in a manner directly

contrary to the specifically expressed intention of Congress.

Conclusion

The Petition for Certiorari should be granted.

Respectfully submitted,

Frank Norton Kern

LAWRENCE CHASE WILSON

Counsel for Petitioner

Reid & Priest

40 Wall Street

New York, New York 10005

June 1976

A-1

APPEND’ X A

In the

UNITED STATES COURT OF CLAIMS

TRIAL DIVISION

Nos. 321-69 and 81-71

(Filed: Sep 20 1974)

Borse Cascape Corporation and Subsidiary Companies

v.

Tue Unirep States

Norton Kern, attorney of record, for plaintiff. Lawrence

C. Wilson, Reid & Priest, of counsel.

Theodore D. Peyser, with whom was Assistant Attorney

General Scott P. Crampton, for defendant. Gilbert E.

Andrews, of counsel.

Opinion*

Fietcuer, Trial Judge: These are consolidated cases in

which plaintiffs seek the recovery of nearly $2,400,000 in

income taxes, plus interest thereon, paid for the years 1955

through 1961. The questions presented are:

1. In the years 1955 throngh 1961, plaintiffs purchased

at an original issue discount commercial paper issued after

* The trial judge’s recommended decision and conclusion of law

are submitted in accordance with Rule 134(h).

¢

A-2

December 31, 1954, and plaintiffs held the paper for not

more than six months.

(a) Is the earned original issue discount taxable

as ordinary income or short-term capital gain?

(b) Is the discount on each note taxable as earned,

since plaintiffs were accrual-basis taxpayers, or is

all of the discount taxable in the year plaintiffs sold

or redeemed the note?

2. Did the plaintiffs’ accounting method of deferring

prepaid income clearly reflect income?

3. Under the circumstances of this case, should the

accrual of earned income be deferred because payment

thereof is not due until a subsequent tax year?

Summary Statement of the Facts Relating

to All Issues

The plaintiffs are Boise Cascade Corporation and sev-

eral of its subsidiary companies. The original petition was

filed by Ebasco Industries Inc. and its subsidiary com-

panies which had filed consolidated tax returns for the tax-

able years 1955 through 1958. Later, Ebasco Industries

was merged with Boise Cascade in a non-taxable transac-

tion, and the necessary steps were taken thereafter to con-

solidate the actions now before the court.

Ebasco Industries was engaged in holding various invest-

ments during the years 1955 through August 31, 1969, the

date of its merger into Boise Cascade. These investments

included marketable securities, short-terin investments, and

ownership interests in various operating subsidiaries which

were (and continue to be) engaged primarily in rendering

engineering, construction, architectural, and consulting

services. Two of such subsidiaries were Ebasco Services,

A-3

Ine. (Kbasco) and Chemical Construction Corporation

(Chemical Construction). Ebasco Industries owned stock

possessing at least 80 percent of the voting power of all

classes of stock of those subsidiary corporations.

During the years in question, Ebasco Industries, Ebasco

Services, and Chemical Construction, as a part of their

investment programs, purchased short-term promissory

notes, with no stated interest, issued by various financial

and industrial corporations, such as C.I.T. Financial Cor-

poration, General Electric Acceptance Corporation, and

General Motors Acceptance Corporation. These notes

were nonregistered bearer instruments containing an un-

conditional promise to pay a specified amount on a specified

date at a specified place, and were purchased at a discount,

that is to say, for an amount less than their face or matur-

ity value from both issuers and holders. None were held

by plaintiffs primarily for sale to customers in the ordinary

course of trade or business. The value of such notes would

increase over the period of time held through accretions of

such original issue discount to the amount paid for the

notes.'

The periods of maturity on the notes ranged from 7 days

to 23 months. Some of the notes were disposed of prior

to maturity and the rest through retirement at maturity.

Although in certain cases the notes sold for a lesser price

than the amount paid and the full original discount attribu-

table to the period held by the plaintiffs, all of the gains

in question were attributable to such discount. Therefore,

all such gains were attributable to the passage of time as

opposed to any market fluctuations. All of the notes

involved herein were issued after December 31, 1954, and

before May 27, 1969; and, with the exception of certain

1. Prices could also vary through market discount and interest

fluctuations. There is, however, no gain attributable to such fluctua-

tions at issue herein.

A-4

notes held by Chemical Construction in 1960 and 1961, all

such notes were held by the plaintiff for a period of not

more than six months.

On their books and in their reports to shareholders, plain-

tiffs accrued the above described discount ratably over the

life of the notes and showed it as income in the year earned

as opposed to the year of sale or retirement. On their

balance sheets these notes were shown at a figure equal to

the principal amount less the unamortized portion of the

discount at which they were purchased. On their consoli-

dated income tax returns for the years 1955 through 1961,

however, the plaintiffs reported all gains in the years in

which they were sold or retired. If the notes were held

for six months or less, the gain was reported as short-term

capital gain; and, after December 31, 1954, the gain on

notes held for more than six months was reported as gain

from the sale or exchange of noncapital assets.

The plaintiffs’ annual shareholder reports included a

certification by independent accountants that the financial

statements were prepared in conformity with generally

accepted accounting principles applied on a basis consistent

with that of the preceding year.

On audit, the Commissioner of Internal Revenue deter-

inined that the gains on the sale or retirement of notes,

regardless of whether held for more than six months, should

he treated as ordinary interest income. The Commissioner

also disagreed with the plaintiffs’ inclusion of such gains in

income entirely in the year realized and determined them

to be taxable as they ratably accrued, as per the plaintiffs’

hook and shareholder report accounting methods.

During the tax years in issue, plaintiffs had consolidated

net capital losses or consolidated net capital loss earryovers

from the five preceding years which exceeded the total

amounts taken into income as short-term capital gain so

that they reported no income on the gains attributable to

A-5

original issue discount on evidences of indebtedness held for

six months or less.

In the typical note transaction involved herein, one of

the plaintiffs would purchase a note with a face amount of

$1,000,000 for $980,000 payable in precisely six months.

Said notes would not be in registered form and would con-

tain no provision for the payment of interest. Six months

later, the note would be retired by the issuing institution

for $1,000,000, resulting in a gain to the particular plaintiff

of $20,000, representing the original issue discount at which

the note had been purchased.? As an alternative to retire-

ment, the note might be sold to a third party for the amount

paid plus ratably accrued discount.

In 1961 and 1962, Chemical Construction realized gain on

the sale or retirement of promissory notes with no stated

interest which had been issued at a discount and held for

periods of more than six months. These notes were issued

after December 31, 1954, were held for investment purposes,

and, except for the holding period, were of the same type as

the notes described above. Chemical Construction included

these amounts on its books and in its shareholder reports

as ratably accrued over the life of the several notes. It

included these amounts in income for tax purposes, how-

ever, in the years of sale or retirement, 1961 and 1962.

Plaintiff included these amounts in income as gain from

the sale or exchange of property not a capital asset. The

Commissioner disagreed with such tax accounting and

included the ratably earned amount of discount in income

for 1960 and redetermined the amounts for 1961 and 1962.

During the period from 1955 through March 5, 1971, the

Commissioner of Internal Revenue did not require the pay-

ment of United States income taxes under section 871(a) (1)

2. Such discount in this situation results in an effective annual

interest rate of approximately 4.08 percent for the six-month period.

A-6

and 881(a) of the Internal Revenue Code of 1954 or the

withholding of such taxes under Code sections 1441 and 1442

with respect to original issue discount on bankers’ accept-

ances, commercial paper, and Treasury bills issued after

December 31, 1954, and before May 28, 1969, where such

evidences of indebtedness were held for not more than six

months by nonresident alien individuals or foreign

corporations.

In its business, Ebasco Services enters into contracts to

perform engineering and similar services. Under the

various terms of these contracts, Ebasco is entitled to bill

fixed sums either in monthly, quarterly, or other periodic

installments, plus such additional amounts as may be pro-

vided for in a particular contract. Depending on the terms

of the different contracts, payments may in some cases be

due prior to the annual period in which such services are

to be performed, and in some cases subsequent thereto.

For a number of years prior to 1959 and continuing to

the time of trial, Ebasco included in its income for both

book and tax purposes amounts attributable to services

which it performed during the taxable year, a procedure

accepted by the Internal Revenue Service on prior audits.

Ebasco determined the amounts so earned by dividing the

estimated number of service hours or days required to com-

plete the particular contract into the contract price. The

resulting quotient represents an hourly or daily rate which

is then multiplied by the number of hours or days actually

worked on the contract during the taxable year. As the

contract is performed, the rate is adjusted to reflect

revised estimates of the work required to complete the

contract.

Where Ebasco billed for services prior to the tax year

in which they were performed, it credited such amounts to

a balance sheet account called “Unearned Income”. Where

A-7

the services were performed in a subsequent period, the

“Unearned Income” account was debited, and such amounts

were included in an income account called “Service

Revenues”. The amount recorded in the latter account

was included in income for both book and tax purposes.

In determining the amount which was to be included in

the “Unearned Income” account, the costs of obtaining the

contract were not taken into account; and, with the excep-

tion of prepaid insurance and similar items, all such

amounts were expensed in the tax year during which they

were incurred. The amounts in the “Unearned Income”

account were treated as liabilities and were excluded from

gross income for each tax year consistently in Ebasco’s

books, records, and shareholder reports, as well as in its

tax returns. All of the amounts included in the account

during one tax year were earned through the performance

of services during the following year and were included in

income for such following tax year. When the amounts

credited to the “Unearned Income” account were collected,

Ebasco had an unrestricted right to the use of such funds.

During the three tax years in issue, an average of over

94 percent of the amounts included in the “Unearned

Income” account was received by Ebasco under contracts

which obligated it to perform engineering services in

connection with the design and construction of electric

generating plants. These contracts either required that

services be performed by a specified date or required that

Ebasco should perform those services “with all reasonable

dispatch and diligence,” as “expeditiously as possible,” or

some comparable requirement. The small remaining

amounts in the account were received either under con-

tracts which required Ebasco to perform specific services

3. These amounts included the cost of preparing bids, proposals,

and estimates, overhead, advertising, and selling expenses.

A-8

in connection with a specific project of a client, or required

Ebasco to provide consultation and advice on an annual

basis for an annual fee.

In addition to its “Unearned” account, Ebasco maintained

an “Unbilled Charges” account computed in the same

manner as the “Unearned Income” account. The balance

in such account represented amounts earned through the

rendering of services, or on partially completed contracts,

or earned prior to contracting under all of which payment

was not then due by the terms of a contract or was not

billable and due prior to execution of a future contract.

Stated another way, the amounts included in this account

were those which Ebasco was not entitled to bill or receive

until a year subsequent to the year in which the services

were actually rendered. Such amounts were recorded in

“Service Revenues” and included in income for tax as well

as book purposes in the taxable year in which the services

were rendered. Likewise, the costs attributable to the

rendering of services which produced the year-end balance

in the “Unbilled Charges” account were deducted from

gross income in the year such services were rendered. In

1959, 1960, and 1961 there were approximately $405,000,

($56,000), and $179,000 of such net amounts, respectively,

carried in the “Unbilled Charges” account.

Plaintiffs’ consolidated income tax returns for 1959

through 1961 were audited by the Government, and the

amounts in the “Unearned Income” account were included

in taxable income for Federal tax purposes. These adjust-

ments were made pursuant to section 446(b) of the 1954

Code under which the Commissioner determined that plain-

tiffs’ deferral method of accounting did not clearly reflect

income. During the same examination for the same tax

years, no adjustments were made to the “Unbilled Charges”

or the “Service Revenues” accounts.

A-9

At trial Ebasco presented expert testimony related solely

to the accounting practices described above. The sole wit-

ness was a qualified certified public accountant and a part-

ner in a major accounting firm. Based on his broad experi-

ence with comparable service companies and his personal

familiarity with the accounting practices of Ebasco, he

expressed his expert opinion with respect to the accounts in

issue and the changes made by the Commissioner.

He testified that the method of accounting used by

Ehasco which employs both an “Unearned Income” account

and an “Unbilled Charges” account and is based on aceru-

ing amounts as income at the time the related services are

performed is in accordance with recognized and generally

accepted accounting principles and clearly reflects Ehasco’s

income. He indicated that this method properly matched

revenues with costs of producing such revenues and is par-

ticularly appropriate in this case because almost all of

Fhaseo’s income is derived from the performance of serv-

ices by its own personnel. He further testified that this

method of accounting was widely used by companies en-

gaged in rendering engineering and similar services, and

that such method clearly reflected the income of Ebasco.

With respect to costs incurred in obtaining contracts,

such as bid preparation, overhead, advertising, and other

selling expenses, the witness considered them to be prop-

erly deducted in the year incurred as continuing costs of

doing and developing business.‘ He explained that these

costs should not properly be amortizable over the life of

any particular contract since they were costs connected

with new business development and were unrelated to per-

formance of the contract.

4. The witness distinguished such costs from commissions which

in some instances may properly be amortized where they relate

directly to the contract involved and thus reduce the amount real-

izable under such contract.

A-10

The accounting method proposed by the Commissioner

requires Ebasco to accrue as income the amounts included

in the “Unearned Income” account aud also requires the

accrual, consistent with plaintiffs’ accounting method, of

amounts in the “Unbilled Charges” aceount. In the opinion

of plaintiffs’ expert, this method of accounting was not in

accordance with generally accepted accounting principles

and did not clearly reflect Ebaseo’s income. To him, the

Commissioner’s method was erroneous in that it required

the inclusion in income of amounts billed but not yet earned

on contracts in one accounting period without at the same

time ackowledging the obligations and costs to be incurred

by Ebasco in the future performance of such contractual

commitments. He termed such method as “hybrid” in that

while it recognized the accrual method with respect to

unbilled charges which were earned but not yet billable, it

had the effect of imposing a cash basis method as to the

billed but unearned charges in the “Unearned Income”

account.

Finally, the witness testified that if Ebaseco were to use

a method of accounting under which amounts in the

“Unearned Income” account would be accrued as income

and amounts in the “Unbilled Charges” account would not

be accrued as income, such method would more clearly

reflect the income of Ebasco than the method of accounting

proposed by the Commissioner. He stated that, while such

method was not technically in accordance with generally

accepted accounting principles, it was a more logical and

consistent approach to use in determining the income of

Ebaseo than the Commissioner’s method.

The plaintiffs invoke a number of grounds which they

helieve require the court to decide these consolidated cases

in their favor. In their first major contention, they argue

that under the provisions of $1232 of the 1954 Code,

A-11

original issue discount on evidences of indebtedness held

for six months or less is to be characterized as short-term

capital gain for tax purposes. They say that (1) $1232

creates a basic rule for capital gains treatment on the sale,

exchange, or retirement of evidences of indebtedness and

unless original issue discount fits within one of the precise

exceptions found in the section, such basic rule will apply;

that (2) in carving out an exception to capital gains treat-

ment under § 1232, Congress acted purposefully in limiting

such exception to gains on the sale or exchange of obliga-

tions held for more than six months; that (3) the legislative

history surrounding § 1232 indicates a Congressional inten-

tion that gains on evidences of indebtedness held not more

than six months are to be treated as short-term capital

gains during the years in issue; and that (4) denial of such

treatment as to short-term evidences of indebtedness will

result in unlawful discrimination in favor of non-resident

alien individuals and foreign corporations during the years

in issue. The plaintiffs also contend that bond discount is

reportable as income solely in the year of sale or exchange

during the tax years in issue.

Plaintiffs’ other contentions do not involve bond discount

but focus on the methods of accounting employed by plain-

tiff, Ebasco Services, during certain tax years. The main

contention is that the deferral method of income accountiag

long employed by Ebasco Services clearly reflects income,

that the method required by the Commissioner of Internal

Revenue does not, and that Ebasco’s method, being other-

wise allowable, should be found acceptable by the court.

As an alternative to this contention, plaintiffs argue that

if Ebaseo Services is required to accrue deferred income

amounts, they should aot be required to accrue charges in

its “Unbilled Charges” account. Each of these contentions

will be treated separately below.

A-12

The Original Issue Discount Question

During the years at issue, there can be little doubt that

original issue discount realized on the sale or exchange

(including retirement) of evidences of indebtedness held

for six months or less must be characterized as short-term

capital gain. To sustain defendant’s contrary contention

that plaintiffs merely received ordinary interest income

from such original issue discount would require the court

to rewrite the applicable Code provision, section 1232(a)

(2), by the simple expedient of eliminating therefrom the

crucial words “held by the taxpayer more than 6 months.”

But, as will be shown, nothing in the legislative history of

the statute or in the decided cases requires such extraor-

dinary mental gymnastics by this court.

Section 1232 was derived from section 117(f) of the

Internal Revenue Code of 1939 which treated redemption

as a sale or exchange of the evidences of indebtedness

issued by a corporation (including any government or

political subdivision thereof), which were in registered

form or had coupons attached. Section 1232 abandoned the

“registered form” or “coupons attached” requirements and

extended capital gain or loss treatment to all bonds or

other evidences of indebtedness issued after December 31,

1954, if they were otherwise capital assets. Section 1232,

however, provided exceptions to this characterization with

regard to certain original issue discount. Under the statute,

original issue discount is defined as the difference between

the issue price and the stated redemption price at maturity

(7.e., the face value). If the particular indebtedness was

issued after December 31, 1954, and held by the taxpayer

for more than six months, such discount would be econ-

sidered as gain from the sale or exchange of property which

is not a eapital asset. Gain attributable to discount on

A-13

evidences of indebtedness held for six months or less was

not mentioned in the statute.‘

As might readily be expected, counsel for plaintiffs find

great significance in this Congressional failure to mention

specifically original issue discount on evidences of indebted-

ness held for six months or less, and from this they argue

that traditional capital gain or loss treatment continues to

apply to such evidences of indebt dness provided only that

they are otherwise capital assets and have been held by the

taxpayer for six months or less. The pertinent parts of

the statute read:

Sec. 1232. Bonds and Other Evidences of Indebted-

ness.

(a) General Rule-—For purposes of this subtitle,

in the case of bonds, debentures, notes, or certificates

or other evidences of indebtedness, which are capital

assets in the hands of the taxpayer, and which are

issued by any corporation, or government or political

subdivision thereof * * *

(2) Sale or Exchange.—

(A) General Rule—* * * [U]pon sale or

exchange of bonds or other evidences of

indebtedness issued after December 31, 1954,

held by the taxpayer more than 6 months, any

gain realized which does not exceed—

(i) an amount equal to the original issue

discount (as defined in subsection (b)) * * *

shall be considered as gain from the sale or

exchange of property which is not a capital

5. The statute was subsequently amended by the Tax Reform

Act of 1969, P. L. 91-172, 83 Stat. 487, so that gain attributable to

original issue discount on evidences of indebtedness held for six

moriths or less is currently characterized as ordinary income by the

terms of the statute.

A-14

asset. Gain in excess of such amount shall be

considered gain from the sale or exchange of a

capital asset held more than 6 months.

(b) Definitions—(1) Original issue discount.—

For purposes of subsection (a), the term “original

issue discount” means the difference between the

issue price and the stated redemption price at

maturity. If the original issue discount is less than

one-fourth of 1 percent of the redemption price at

maturity multiplied by the number of complete years

to maturity, then the issue discount shall be con-

sidered to be zero.° * * *

In searching for the proper interpretation of section 1232,

as applied to the present problem, the intent of Congress

in enacting the section becomes highly relevant. That inten-

tion is clearly mainfested by language found in both the

Reports of the Committee on Ways and Means and the

Committee on Finance where it is stated:

Paragraph (1) restates the content of present law.

For bonds or other evidences of indebtedness issued

after December 31, 1954, the bill abandons present

restriction of capital treatment on retirement to

bonds and other evidences of indebtedness which have

interest coupons attached or which are in registered

form. Redemption of all bonds and other evidences

of mdebtedness will receive capital gain or loss

treatment on redemption if issued after December 31,

1954, and if they are otherwise capital assets, except

to the extent that the recovery of issue discount is

subject to paragraph (2) [i.e. section 1232(a)(2)].

(House Report No. 1337, 83d Cong., 2d Sess., p.

A275.) [Emphasis supplied. ]

6. The foregoing is a pertinent extract from the statute involved,

as amended by the Technical Amendments Act of 1958, P.L. 85-866,

72 Stat. 1606. The amendments made thereby were merely tech-

nical and clarifying in nature without substantive relevance to the

issue involved herein.

A-15

The Report of the Committee on Finance contains an

identical statement. See Senate Report 1622, 83d Cong.,

2d Sess., p. 433.

Defendant makes light of the foregoing and relies instead

on committee explanations that original issue discount “is

a form of interest income and in fact is deductible as an

interest payment by the issuing corporation.” See, H. Rep.

No. 1337 and 8. Rep. No. 1622, supra. The statement quoted

is, of course, correct and accurately reflects such decisions

of the U. S. Supreme Court as United States vy. Midland-

Ross Corporation, 381 U.S. 54, 57 (1965) and Helvering v.

Union Pacific Ry. Co., 298 U.S. 282 (1934). Cf. Commis-

sioner vy. National Alfalfa Dehydrating & Milling Co.,

US. , 42 U.S.L.W. 4798, 4801, decided May 28, 1974,

on the narrow question of whether discount may result

when debt obligations are issued in exchange for property

other than cash.’

7. In footnote 9 of its National Alfalfa opinion, the Court made

a generalized comment on the section 1232(a)(2) problem as

follows :

It was unsettled for some time whether income realized by an

owner of an original discount obligation was taxable to that

owner as ordinary income or as capital gain. In Commissioner

v. Caulki..s, 144 F.2d 482 (CA6 1944), decided under the 1939

Code, it was held that gain upon surrender of an installment

certificate issued at a discount was capital gain. Other circuits,

however, thereafter held that income attributable to the discount

was ordinary income. * * * [Citing cases. ]

The issue was settled by the decision in United States v. Mid-

land-Ross Corp., 381 U.S. 54 (1965), when the Court held that

earned original issue discount is not entitled to capital gain

treatment under the 1939 Code.

Congress, in enacting § 1232 of the 1954 Code, adopted a differ-

ent approach to earned original issue discount, referring to it

as “a form of interest income” in S. Rep. No. 1622, 83d Cong.,

2d Sess., 112 (1954). Under §1232(a)(2), gain from the

sale or redemption of a corporate obligation issued at a discount

is taxed as the gain from the sale of a noncapital asset. If the

obligation is held by the original purchaser to maturity, the

entire amount of the discount is so taxed, but if it is sold or

A-16

In Mdidland-Ross, supra, the Supreme Court gave con-

sideration to non-interest bearing promissory notes origi-

nally issued at a discount most of which had been held

by the taxpayer for over six months but one of which was

held for six months or less (as in the present case). It

was conceded by the parties that any gain attributable to

such discount was the economic equivalent of interest in

compensation for the use of money. ‘The taxpayer had,

nonetheless, reported such gain as capital gain under sec-

tion 117 of the 1939 Code. In holding against the taxpayer,

the Court premised its decision on the narrow construction

traditionally given the term, “capital asset.” Thus, at 381

U.S. 54, 56-57:

*** Although original issue discount becomes prop-

erty when the obligation falls due or is liquidated

prior to maturity and 9 117(a)(1) defined a capital

asset as “property held by the taxpayer,” we have

held that

not everything which can be called property in the

ordinary sense and which is outside the statutory

exclusions qualifies as a capital asset. This Court

has long held that the term “capital asset” is to be

construed narrowly in accordance with the purpose

of Congress to afford capital-gains treatment only

in situations typically involving the realization of

appreciation in value accrued over a substantial

period of time, and thus to ameliorate the hardship

of taxation of the entire gain in one year. Com-

missioner v. Gillette Motor Co., 364 U.S. 130, 134.

See also Corn Products Co. v. Commissioner, 350

U.S. 46, 52. In applying this principle, this Court

redeemed before maturity, only the portion accrued up to the

date of sale or redemption is so taxed. * * *

It will be seen that these observations do not quite reach the pre-

cise issue here involved. For an extensive discussion of National

Alfalfa, see comment in 41 Jour. of Tax. 134 (Sept. 1974).

A-17

has consistently construed “capital asset” to exclude

property representing income items or accretions to

the value of a capital asset themselves properly

attributable to income. * * *

* * * Similarly, earned original issue discount can-

not be regarded as “typically involving the realiza-

tion of appreciation in value accrued over a substan-

tial period of time... [given capital gains treat-

ment] to ameliorate the hardship of taxation of the

entire gain in one year.”

Earned original issue discount serves the same

function as stated intecest, concededly ordinary

income and not a eapital asset; it is simply “com-

pensation for the use or forbearance of money.” * * *

This court had itself anticipated the decision in Midland-

Ross. See, Pattiz v. United States, 160 Ct. Ci. 121, 311 F.2d

947, (1963) where, speaking for a unanimous court, Judge

Whitaker observed at 160 Ct. Cl. 127, 311 F.2d 950:

We think this * * * correctly states the sort of gain

Section 117(f) was intended to cover and the part it

was not intended to cover. It was intended to cover

gain derived from appreciation in value, or a case

where the purchase was made from some one other

than he who issued them at an advantageous price,

but certainly not a case where an original issue of

bonds or notes were sold at a discount, in lieu of pay-

ment of interest on them.

Thus, on the basis of Midland-Ross and Pattiz, it is

entirely clear that under the 1939 Code, the discounted

short-term obligations owned by plaintiffs would produce

income in the nature of interest and hence taxable at ordi-

A-18

nary rates.* This conclusion, however, cannot be the end

of the matter.

The present cases arise under section 1232 of the 1954

Code, not under section 117 of the 1939 Code. In Midland-

Ross, the Supreme Court expressly disavowed any inten-

tion to rule on the provisions of section 1232 of the 1954

Code, stating that it had “no view on the construction of

this statute.” 381 U.S. 54, 58, ftn. 5.2 Much later, the

Court in National Alfalfa, supra, referred to section 1232

of the 1954 Code as having “adopted a different approach

to earned original issue discount, referring to it as ‘a form

of interest income...’”. See footnote 7, supra.

Unlike the situation in Midland-Ross, I believe that in

the present cases, plaintiffs have established that Congress

in enacting section 1232 of the 1954 Code intended to treat

sales or exchanges of evidences of indebtedness as capital

transactions and to carve out from such treatment certain

exceptions including gain attributable to original issue dis-

count on evidences of indebtedness held for more than six

months. Plaintiffs have further established to my satis-

faction that Congress intended to treat gains which were

not subject to the exceptions provided in section 1232, such

as original issue discount on evidences of indebtedness held

for not more than six months, as short-term capital gains.

Adopting the defendant’s position to the contrary would

necessarily require the court to rewrite section 1232(a) (2)

by simply ignoring the words “held by the taxpayer more

than 6 months.” I cannot believe that such drastic rewrit-

ing of the statute would constitute permissible interpreta-

tion.

8. See 1954 Code, § 61(a) (4), 26 U.S.C. § 61(a) (4), and Treas.

Reg. § 1.61-7(a) and (c).

9. Similarly, this court concluded in Pattiz, supra, that:

The 1954 Code does not affect the transaction in this case.

The 1954 Code effected a change in the law. 160 Ct. Cl. 128,

311 F.2d 950 [Emphasis supplied. ]

A-19

Neither party has made reference to legislative history

(and I have found none independently) which satisfactorily

explains the reason why Congress in enacting section

1232(a)(2) used the words “held by the taxpayer more than

6 months”’—traditional words typically used by Congress

only in the capital gain and loss provisions of the various

revenue statutes. If, as defendant apparently contends,

Congress in section 1232 intended to provide that all

original issue discount should be taxed as though it were

simply interest income, statutory language to that effect

could have been easily framed.’® Is it possible that the

obvious failure to do so is rerely an instance of what

Judge Nichols has referred to as “sheer inadvertence in the

legislative process”? Dissenting in Schmid v. United States,

193 Ct. Cl. 780, 789, 436 F. 2d 987, 992 (1971), and cited

with approval by the Supreme Court in Cass v. United

States, US. , decided May 28, 1974, slip

op. p. 11.

That some inadvertence might have existed is perhaps

indicated by the fact that in section 413(a) of the Tax

Reform Act of 1969, P. L. 91-172, 83 Stat. 487, Congress

amended section 1232 of the 1954 Code to make it apply to

discount on corporate bonds held for not more than six

months, provided they were issued after May 27, 1969.

However, in explaining the change, the Report of the

Committee on Finance stated:

The rules provided by the bill regarding the treat-

ment of original issue discount are not to apply in

the case of bonds or other evidences of indebtedness

issued by any government or political subdivision

(or in the case of bonds or other evidence of indebted-

ness issued by a corporation on or before October 9,

10. This principle was referred to by the late Judge Jerome

Frank as the “familiar easy-to-say-so-if-that-is-what-was-meant

rule.” Commissioner v. Beck’s Estate, 129 F.2d 243, 245 (2d Cir.,

1942).

A-20

1969). In these cases, the rules of present law

regarding the treatment of original issue discount

on the sale or exchange of a bond which is a capital

asset in the hands of the taxpayer and which has

been held by the taxpayer for more than 6 months

are to continue to apply. Jn addition, in these cases,

gam on the sale or exchange of a bond or other evi-

dence of indebtedness which is a capital asset in the

hands of the taxpayer but which has not been held

by the taxpayer for more than 6 months is to be

treated as a short-term capital gain as under present

law. (Senate Report No. 91-552, 91st Cong., Ist

aa p. 148, 1969-3 C.B. 423, 518) [Emphasis sup-

plied.

While it is true, as suggested by defendant, that the views

of a subsequent Congress form a hazardous basis for

ascertaining the intent of an earlier one," the significance

of the above excerpt is its indication of Congressional

understanding of this area of law which would seem to

negate the possibility of inadvertence. Whether the Con-

gressional actions described above (resulting, as they do,

in a form of so-called “loophole”) reflect sound tax policy

is not a question for the judiciary. In this connection, the

words of Mr. Justice Stewart in United States v. Correll,

389 U.S. 299 (1967) shoulc be borne in mind:

.. we do not sit as a committee of revision to per-

fect the adininistration of the tax laws. 389 U.S.

306-307.

11. United States v. Price, 361 U.S. 304, 313 (1 ; 7

States v. Philadelphia Nat. Bank, 374 U.S. 321, 398-349 ( 1963)

Waterman S. S. Corp. v. United States, 381 U.S. 252, 269 (1965) :

United States v. Southwestern Cable Co., 392 U.S. 157, 170 (1968) .

Brown v. United States, 192 Ct. Cl. 203, 210, 426 F.2d 355. 357

(1970) ; and Humble Oil & Refining Co. v. United States, 194 Ct

Cl. 920, 932, 442 F.2d 1362, 1369 (1971).

eer

ee ee

A-21

Accordingly, I conclude that gains attributable to original

issue discount on evidences of indebtedness issued prior to

May 28, 1969, and held for not more than six months should

be treated as short-term capital gains.’’

“Seconp Issup OMITTED”

Recommended Conclusion of Law

Upon the foregoing findings of fact and opinion, which

are adopted by the court and made a part of the judgment

herein, the court concludes as a matter of law that plaintiff

is entitled to recover, and judgment is entered to that effect,

with the determination of the amount of recovery to be

reserved for further proceedings under Rule 131(¢) in

accordance with this opinion.

a

12. In the view I take of the case, this conclusion renders moot

two subsidiary points raised by the parties. First, plaintiff argues

that defendant’s treatment of original issue discount in the present

case is so different from the treatment accorded such discount in the

hands of non-resident aliens and foreign corporations as to be ille-

gally discriminatory in favor of foreign persons and against United

States persons. However, should my view of the law prevail, there

is no such discrimination, and the question becomes moot. Secondly,

while conceding that gain attributable to original issue discount on

evidences of indebtedness held for more than 6 months is taxed only

in the year realized through sale or exchange (Df’s Brief, p. 24),

defendant contends that on short-term evidences of indebtedness held

by accrual basis taxpayers (such as plaintiffs), the original issue dis-

count is taxable on a ratably accrued basis in the same manner as

ordinary interest income. However, my treatment of such discount

as short-term capital gain places the question within the general scope

of defendant’s concession that discount on longer term evidences of

indebtedness is taxable only when realized, thus eliminating the

question.

B-1

APPENDIX B

IN THE

UNITED STATES COURT OF CLAIMS

Nos. 321-69, 81-7i

(Decided January 28, 1976)

Borst CascaDE CORPORATION AND SuBSIDIARY COMPANIES,

Vv.

THe Unitrep States

Norton Kern, attorney of record for plaintiff. Lawrence

C. Wilson, Reid & Priest, of counsel.

Donald H. Olson, with whom was Assistant Attorney Gen-

eral Scott P. Crampton, for defendant. Theodore D. Pey-

ser, of counsel.

Before Laramore, Senior Judge, Davis, SKeE.Ton,

Nicos, Kasurwa, Kunzic, and Bennett, Judges.

Opinion

Per Curtam: These are consolidated cases, in which

plaintiffs seek the recovery of nearly $2,400,000 in income

taxes plus interest thereon, paid for the years 1955 through

1961. They now come before the court on exceptions by the

parties to the recommended decision filed by Trial Judge

Lloyd Fletcher, on September 20, 1974, pursuant to Rule

B-2

134(h), having been submitted to the court on the briefs

and oral argument of counsel. He held for the plaintiffs

on all the significant issues. After briefing and oral argu-

ment, the court agrees with the trial judge in part, and

disagrees in part. Our disagreement extends to all the por-

tions of the opinion that deal with plaintiffs’ gains from

original issue discount. In General Foods Corporation v.

United States, No. 70-73 (decided today), the stipulated

facts as to this issue offer no legal distinction from the

found facts at bar. The court has there held that the gains

attributable to original issue discount, on evidences of in-

debtedness issued after December 31, 1954, and before May

28, 1969, and held by plaintiff for periods of not more than

six months, were ordinary income rather than short term

eapital gains. Moreover, it has held that any alleged incon-

sistent treatment of foreign taxpayers by the Internal

Revenue Service does not affect the validity of its position.

Accordingly, the discount was taxable currently as earned

hy these acerual basis taxpayers. In view of our full state-

ment of reasons in General Foods, to which reference is

made, it is unnecessary to repeat it here. The fact findings

are left standing. Though not printed herewith, they have

heen furnished to the parties, and will suffice to document

the identity of issues.

“Seconp Issur Omirrep”

Davis, Judge, coneurring: On the issue of original issue

discount, T refer to my coneurring opinion in General Foods

Corp. v. United States, No. 70-73. On the so-called

“secounting” issue, I join the court in adopting (with some

modifications) Trial Judge Fletcher’s opinion.

B-3

Conclusion of Law

Upon the findings of fact and opinion, which are adopted

by the court and made a part of the judgment herein, the

court concludes as a matter of law that plaintiff is entitled

to recover on the accounting issue and judgment is entered

to that effect, with the determination of the amount of re-

covery to be reserved for further proceedings under Rule

131(e) in accordance with this opinion. Judgment is en-

tered for defendant and the petitions are dismissed with

repect to original issue discount.

C-1

APPENDIX C

IN THE

UNITED STATES COURT OF CLAIMS

Nos. 321-69, 81-71

Borse CascapE CorRPORATION AND SuBsipiaky COMPANIES

7.

THe Untrep States

Before Davis, Judge, Presiding, Laramore, Senior Judge,

SKeE.Ton, NicHois, Kasutwa, Kunzic and Bennett, Judges,

en bane.

Order

In the court’s per curiam opinion of January 28, 1976,

there occurs an inadvertent error which the court sue

sponte corrects by this order.

References are to the slip opinion:

Page 2, Line 7; Delete entire sentence reading:

Moreover, it has held * * * validity of its position.

Page 2, following line 16 (end of above paragraph) insert

new paragraph reading:

With respect to the claim of unlawful discrimina-

tion in favor of nonresident taxpayers, in that the

Commissioner failed to tax as ordinary income orig-

inal issue discount on their indebtedness held for six

months or less, the court is of the opinion that the

taxation of nonresident foreign taxpayers raises

such different considerations that it cannot be com-

pared, for equal protection purposes, to the taxation

of domestic taxpayers.

By the Court

Feb 27 1976

oe Owes Cen ee es.

D-1

APPENDIX D

IN THE

UNITED STATES COURT OF CLAIMS

No. 70-73

(Decided January 28, 1976)

GENERAL Foops Corporation,

v.

THe Unirep States

David I. Granger, attorney of record, for plaintiff.

Harold D. Murry, Jr. and Clifford, Warnke, Glass,

Mcllwain & Finney, of counsel.

Richard F. Treacy, Jr., with whom was Assistant Attor-

ney General Scott P. Crampton, for defendant. Theodore

D. Peyser and Donald H. Olson, of counsel.

Before Laramore, Senior Judge, Davis, SKevton,

NicHo.is, Kasuiwa, Kunzic, and Bennett, Judges.

OPINION

Kasuiwa, Judge, del.vered the opinion of the court:

This action comes before us on a stipulation of facts. The

essential facts stipulated are recited below. Each of the

parties claims that it is entitled to judgment on said stipu-

D-2

lated facts. We hold for the defendant and against the

plaintiff for reasons hereafter stated.

This is an action arising under the Internal Revenue Code

of 1954 for the taxable year 1959, beginning April 1, 1958,

and ending March 31, 1959. Since Section 1232 of the

Internal Revenue Code of 1954 is the center of discussion,

we shall first quote by footnote its relevant portions.’

1. SEC. 1232. BONDS AND OTHER EVIDENCES OF

INDEBTEDNESS.

“(a) GENERAL RULE.—For purposes of this subtitle, in the

case of bonds, debentures, notes, or certificates or other evidences

of indebtedness, which are capital assets in the hands of the taxpayer,

and which are issued by any corporation, or government or political

subdivision thereof-—

“(1) RETIREMENT.—Amounts received by the holder on

retirement of such bonds or other evidences of indebtedness shall be

considered as amounts received in exchange therefor (except that in

the case of bonds or other evidences of indebtedness issued before

January 1, 1955, this paragraph shall apply only to those issued with

interest coupons or in registered form, or to those in such form on

March 1, 1954).

“(2) SALE OR EXCHANGE.—

“(A) GENERAL RULE.—Except as provided in subparagraph

(B), upon sale or exchange of bonds or other evidences of indebted-

ness issued after December 31, 1954, held by the taxpayer more than

6 months, any gain realized which does not exceed—

“(i) an amount equal to the original issue discount (as defined in

subsection (b)), or

“(ii) if at the time of original issue there was no intention to call

the bond or other evidence of indebtedness before maturity, an

amount which bears the same ratio to the original issue discount (as

defined in subsection (b)) as the number of complete months that the

bond or other evidence of indebtedness was held by the taxpayer

bears to the number of complete months from the date of original

issue to the date of maturity,

“shall be considered as gain from the sale or exchange of property

which is not a capital asset. Gain in excess of such amount shall be

considered gain from the sale or exchange of a capital asset held

more than 6 months.

“(B) EXCEPTIONS.—This paragraph shall not apply to—

D-3

Plaintiff, General Foods Corporation, is a corporation

duly organized and existing under the laws of the State of

Delaware, with its principal place of business at White

Plains, New York. The stipulation shows that General

Foods Corporation’s principal business is the production

and sale of a wide variety of food and grocery products,

many in package form under nationally advertised brand

names. General Foods Corporation is not now, nor has it

ever been, a dealer in securities. During the taxable year

1959, plaintiff held promissory notes with no stated interest

issued by various corporations. The notes, commonly

referred to as commercial paper, were ne»-registered

bearer instruments containing an unconditional promise

to pay a specified amount on a specified date at a specified

place. Plaintiff purchased each of the notes from the

issuer or from Goldman, Sachs & Company, a dealer in

securities, at an amount less than its face value. The notes

were held by plaintiff for periods ranging from 43 days to

181 days. The plaintiff held each note for a period less

“(i) obligations the interest on which is not includible in gross

income under section 103 (relating to certain governmental obliga-

tions), or

“(ii) any holder who has purchased the bond or other evidence

of indebtedness at a premium.

“(C) DOUBLE INCLUSION IN INCOME NOT RE-

QUIRED.—This section shall not require the inclusion of any

amount previously includible in gross income.

“(b) DEFINITIONS.—

“(1) ORIGINAL ISSUE DISCOUNT.—For purposes of sub-

section (a), the term “original issue discount” means the difference

between the issue price and the stated redemption price at maturity.

If the original issue discount is less than one-fourth of 1 percent of

the redemption price at maturity multiplied by the number of com-

plete years to maturity, then the issue discount shall be considered to

be zero. For purposes of this paragraph, the term “stated redemption

price at maturity” means the amount fixed by the last modification of

the purchase agreement and includes dividends payable at that time.”

* . * * *

[As amended through 1959.]

D4

than six months and at maturity received the face amount

from the issuer. Plaintiff retired all of the notes in the

taxable year 1959. The notes were purchased by the plain-

tiff for investment and were not property of a type that

would be held in inventory or for sale to customers in the

normal course of business. All of the notes involved in

this case were issued after December 31, 1954, and before

May 27, 1969. The amount received by the plaintiff on

retirement of each of the notes which exceeded the amount

paid by plaintiff for the note was original issue discount;

no part of that amount was attributable to market fluctua-

tions as opposed to the passage of time.

On its Federal income tax return for the taxable year

1959, beginning April 1, 1958, and ending March 31, 1959,

plaintiff reported short-term capital gains of $608,598.99.

This was the amount received over and above the purchase

prices from the retirement at maturity of the total of

$90,750,000 non-interest-bearing corporate notes purchased

hy the plaintiff at a discount and held for less than six

months. During the taxable year 1959 plaintiff had net

capital loss carryovers from the prior years in the amount

of $518,840.74. There is no dispute as to this loss carry-

over. Plaintiff claims that it is entitled to deduct the loss

carryover from the above-mentioned gain of $608,598.99

because the gain is short-term capital gain.

On October 29, 1965, the Commissioner of Internal Reve-

nue mailed to the plaintiff a statement of tax Cac, assessing

a deficiency in income taxes for the taxable year 1959 in the

amount of $345,638 plus interest. Plaintiff paid this amount

plus interest on November 8, 1965. The amount of $208,291

of this deficiency assessment resulted from the Commis-

sioner treating as interest income rather than as short-term

capital gain the amount of $608,598.99 received by plaintiff

over and above the purchase prices on the retirement at

ee es ee ee «

bitin veincterenctsct stents

D-5

maturity of the non-interest-bearing corporate notes pur-

chased by the plaintiff at a discount for investment and held

for less than six months. On November 6, 1967, plaintiff

filed a claim for refund of this amount of $208,291 plus the

interest paid thereon together with interest as provided by

law, representing that part of the assessed deficiency attri-

butable to treating as interest income rather than short-

term capital gain the amounts over and above the purchase

prices, received by plaintiff on the retirement of the corpo-

rate notes. On March 1, 1971, the Commissioner of Internal

Revenue disallowed in its entirety plaintiff’s claim for

refund. This action for refund was filed in this court on

February 27, 1973.

Both parties agree that the sole issue presented is

whether gain attributable to original issue discount on evi-

dlences of indebtedness issued after December 31, 1954, and

before May 28, 1969, and held by plaintiff for periods of

not more than six months is taxable as short-term capital

gain on the retirement of the indebtedness.

The decision in this case rests, as we shall hereafter show,

upon Section 1221 but since plaintiff’s arguments center on

Section 1232, we shall first examine Section 1232. Plaintiff

claims that Section 1232 gives capital treatment to the gain

in this case. Defendant, on the other hand, states that Sec-

tion 1232 is not relevant to the original issue discount herein

since Section 1232 only deals with notes which are capital

assets in the hands of the taxpayer and since original issue

discount under case law is not a capital asset, Section 1232

does not apply.

We shall first discuss the history of Section 1232. Sec-

tion 206(a)(1) of the Revenue Act of 1921, e. 136, 42 Stat.

227, 232, defined the term “capital gain” as “taxable gain

from the sale or exchange of capital assets * * *.” This

provision, without material change, was reenacted by Sec-

D-6

tion 208(a)(1) of the Revenue Act of 1924, ec. 234, 43 Stat.

253, 262; by Section 208(a)(1) of the Revenue Act of

1926, ce. 27, 44 Stat. 9, 19; by Section 101(c)(1) of the

Revenue Act of 1928, e. 852, 45 Stat. 791, 811; and by See-

tion 101(c)(1) of the Revenue Act of 1932, c. 209, 47 Stat.

169, 191.

The question arose as to whether, under these statutes, a

redemption (retirement) of bonds constituted a sale or ex-

change within the meaning of that provision and successor

statutes. A conflict of judicial decisions’ on the matter led

Congress to enact Section 117(f) of the Revenue Act of

1934, ce. 277, 48 Stat. 680, 715, which is the predecessor of

Section 1232(a)(1). The addition of that provision assured

that the retirement of notes would constitute an exchange.

While Section 117(f) served to resolve the question of

whether the retirement of a note constituted a “safe [sic] or

exchange,” it created a new round of litigation as to whether

gain attributable to original issue discount was an amount

received in exchange for a capital asset and, consequently,

qualified for long-term capital gain treatment. In Commis-

sioner v. Caulkins, 144 F. 2d 482 (6th Cir. 1944), the Sixth

Circuit read Section 117(f) to permit long-term capital gain

treatment for the $5,000 gain realized, functionally, as

original issue discount. The court noted (at 484) that if the

application of Section 117(f) resulted in inconsistencies and

inequalities, “the correction of this defect in the operation

of the statute is for Congress and not for the courts.” The

Supreme Court in United States v. Midland-Ross Corp., 381

U.S. 54 (1965), subsequently disagreed with the holding of

Caulkins that the proceeds received upon a face-amount

certificate cannot be divided into separate increments which

represent interest income and capital gain after other

2. See Fairbanks v. United States, 306 U.S. 436 (1939).

ao es on on carne

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D-7

courts, including this court, refused to follow the rationale

of the Sixth Circuit. See Pattiz v. United States, 160 Ct. Cl.

121, 311 F. 2d 947 (1963) ; Commissioner v. Morgan, 272 F.

2d 936 (9th Cir. 1959); Rosen v. United States, 288 F. 2d

658 (3d Cir. 1961) ; United States v. Harrison, 304 F. 2d 835

(Sth Cir. 1962), cert. denied, 372 U.S. 934 (1963).

The legislative history of the revised version of Section

117(f) (Section 1232) indicates that Congress chose to heed

the admonition of the court in Cawlkins to correct, at least

partially, a possible defect in the statute which, under the

holding of Cawkins, allowed the issuing corporation an in-

terest deduction for original issue discount, but taxed the

holder at more favorable long-term capital gain rates if the

notes were held more than six months. The following lan-

guage of the Senate Report accompanying the enactment of

Section 1232 of the 1954 Code graphically illustrates the

situation which Congress faced at the time (S. Rep. No.

1622, 83d Cong., 2d Sess. 112 (1954)):

(C) Bonds and Other Debt (sec. 1232)

(1) House changes accepted by committee

Under section 117(f) of present law, when a cor-

porate or Government bond in registered form or

with coupons attached is retired the transaction is

treated as a sale or exchange. There is some uncer-

tainty as to the status of proceeds in these transac-

tions, i.e., as capital gain or as interest income where

the bond or other evidence of indebtedness has been

issued at a discount (see I.T. 3486, 1941-2, C.B. p. 76,

as compared with Comm. v. Caulkins, 144 F. 2d 482).

In these cases, that part of the amount received on

a sale or exchange which may represent a partial

recovery of discount on original issue is a form of

interest income and in fact is deductible as an inter-

est payment by the issuing corporation.

D-8

Effective with respect to bonds issued after De-

cember 31, 1954, the House bill removes doubt in this

area by providing that any gain realized by the

holder of a bond attributable to the original issue dis-

count will be taxed as ordinary income. * * *

The solution to the problem perceived by Congress as a

result of Caulkins was a limited one. Together with other

technical amendments to the old Section 117(f), which

amendments have no effect on the instant problem, Con-

gress added subsection (a)(2) to Section 1232 to plug the

revenue loss resulting from the allowance, under Cauwlkins,

of long-term capital gain treatment.

Congress reenacted most of the text of Section 117(f) as

Section 1232(a) of the 1954 Code and specifically added the

limiting language “which are capital assets” to the language

“bonds, debentures, notes, or certificates or other evidences

of indebtedness.” It explained this addition as follows (S.

Rep. No. 162%, supra, at 454):

Section 117(f) does not itself extend capital-gain

treatinent to any transaction but simply provides one

of several requirements for such treatment on retire-

ment of certain securities. Paragraph (2) of this

section [Section 1232], however, provides specifically

for eapital-gain treatinent and, therefore, the phrase

is inserted in the first sentence of this section to the

effect that this section only applies to bonds and

other evidences of indebtedness which are capital

assets in the hands of the taxpayer. * * * [Mmphasis

supplied. ]

We turn now from the history to the present positions of

the parties. Plaintiff first argues that Section 1232(a) (1)

makes ihe retirement of these notes equal to an exchange.

Since the section does not provide for special treatment of

original issue discount for notes held six months or less as

— — ee

D-9

it does for original issue discount on notes held more than

six months in Section 1232(a)(2), notes held for six months

or less fall under Section 1232(a)(1). Their retirement is

treated as an exchange and an exchange of a capital asset

results in capital gain.

This is the point at which the parties separate. The

defendant states that Section 1232(a)(1) does not apply;

in fact, none of Section 1232 applies. In Section 1232(a)

the general rule refers to notes “which are capital assets

in the hands of the taxpayer.” Defendant argues that under

ease law the original issue discount is separable from the

note and is not a capital asset. Since Section 1232 is only

applicable to capital assets, it does not apply to original

issue discount on notes held for six months or less. There-

fore, we must examine the case law to determine how this

item should be treated.

It has heen held by the Supreme Court and other courts

that an item of ordinary income derived from an ineome-

producing capital asset retained its character even though

sold as part of property which was a capital asset.’ In

United States vy. Midland-Ross Corp., supra, the Supreme

Court held that original issue discount was ordinary income

and not capital gain. The Court held as follows at 56-57:

————

3. Watson v. Commissioner, 345 U.S. 544 (1953) [profit from

sale of an orange grove attributable to unmatured crop was ordinary

income|; Commissioner v. Gillette Motor Transport, Inc., 364 U.S.

130 (1960) [award for wartime possession of trucking company by

Government was rental income and not capital gain from involunta

conversion]; Commissioner v. P. G. Lake, Inc., 356 U.S. 260 (1958)

[consideration for assignment of oil payment right carved out from

a larger mineral interest producing ordinary income was held to be

taxable as ordinary income]; Tunnel! v. United States, 259 F. 2d 916

(3d Cir. 1958) [proceeds of sale of interest in law partnership, to

the extent attributable to accounts receivable, were taxable as

ordinary income]; Fisher v. Commissioner, 209 F. 2d 513 (6th Cir.

1954) cert. denied, 347 U.S. 1014 [proceeds of sale of notes repre-

senting defaulted interest were ordinary income].

D-10

* * * Although original issue discount becomes

property when the obligation falls due or is liqui-

dated prior to maturity and §117(a)(1) defined a

capital asset as “property held by the taxpayer,” we

have held that

“not everything which can be called property in

the ordinary sense and which is outside the statu-

tory exclusions qualifies as a capital asset. This

Court has long held that the term ‘capital asset’ is

to be construed narrowly in accordance with the

purpose of Congress to afford capital-gains treat-

ment only in situations typically involving the

realization of appreciation in value accrued over a

substantial period of time, and thus to ameliorate

the hardship of taxation of the entire gain in one

year.” Commissioner v. Gillette Motor Co., 364

U.S. 130, 134.

See also Corn Products Co. v. Commissioner, 350

U.S. 46, 52. In applying this principle, this Court

has consistently construed “capital asset” to exclude

property representing income items or accretions to

the value of a capital asset themselves properly attri-

butable to income. * * * [Footnote omitted. ]

In an earlier decision in Pattiz v. United States, supra, this

court held as follows:

We think the discount at which these notes were

sold was in lieu of the payment of interest on them,

and that the difference in the amount paid for them

and the amount at which they were redeemed was

ordinary income. In our opinion it was not intended

by §117(f) of the Interna] Revenue Code of 1939 to

treat it as a capital gain. [160 Ct. Cl. at 128, 311 F.

2d at 950.)

Judge Whitaker in his Pattiz opinion examines the relevant

eases of several circuits and comes to the conclusion that

Section 117(f), the predecessor of Section 1232(a)/1), was

ee er

D-11

intended to cover capital gain resulting from the retirement

of a note in contrast to original issue discount gain repre-

senting compensation for the use of money.

That decision agrees with the Third Circuit’s conclusion

in Rosen v. United States, supra. In Rosen the taxpayer

argued that Section 1232(a)(1) was an overriding statute

which prevented original issue discount from being taxed as

interest under Section 61. The court at 661 stated the issue

to be:

* * * whether the requirement of Section 1232(a)

(1) that amounts received on retirement of certain

“evidences of indebtedness shall be considered as

amounts received in exchange therefor” is tanta-

mount to saying that the entire increment realized in

such an exchange must be taxed as capital gain

rather than ordinary income.

The court then looked at the tax treatment of fully earned

increments upon the sale or exchange of capital assets and

concluded that the general rule applies: the right to receive

ordinary income from a capital asset is not changed into

capital gain upon the sale of that asset together with the

right. Section 1232(a)(1) did not abrogate that rule but,

rather, provided for capital treatment for the capital incre-

ment which was realized upon retirement.

Plaintiff seizes upon a sentence in a Senate Committee on

Finance Report to the Tax Reform Act of 1969, Pub. L. No.

91-172, 83 Stat. 487,‘ to argue that Section 1232 was intended

4. S. Rep. No. 91-552, 91st Cong., Ist Sess. (1969) at 148:

“* * * In * * * [the case of Government evidences of indebt-

edness or in the case of pre-October 10, 1969, corporate evi-

dences of indebtedness] gain on the sale or exchange of a bond

or other evidence of indebtedness which is a capital asset in the

hands of the taxpayer but which has not been held by the tax-

payer for more than 6 months is to be treated as a short-term

capital gain as under present law.”

D-12

to overrule Midland-Ross, supra. This statement was made

without any basis in the 1954 version of Section 1232. The

views of a subsequent Congress as to the meaning of am-

biguous language of a previous Congress do not earry great

weight. An attempt to amend legislation of a previous

Congress by Committee Report must be rejected.

Plaintiff also states that it should prevail because the

Commissioner unlawfully discriminated in favor of simi-

larly situated taxpayers. The basis of this claim is that the

Commissioner failed to tax as ordinary income original

issue discount on evidences of indebtedness held for six

months or less by nonresident alien individuals and foreign

corporations. In plaintiff’s claim for refund no mention is

made of a claim of unlawful discrimination. Accordingly,

this court is without jurisdiction to rule upon a claim not set

out in plaintiff’s claim for refund. See Section 7422(a) oi

the 1954 Code and Treas. Reg. § 301.6402-2(b)(1) (1956) ;

Union Pacific R.R. v. United States, 182 Ct. Cl. 103, 108, 389

F. 2d 437, 442 (1968), and the cases cited therein.

We find for the defendant and against the plaintiff.

Plaintiff’s petition is dismissed. Judgment is entered for

the defendant and against the plaintiff.

Davis, Judge, concurring in the result:

My vote to dismiss the petition is not founded on the use

in section 1232 of “capital assets,” the primary purpose of

which IT take to be to separate securities held for investment

from those held in the ordinary course of trade or business.

5. United States v. Price, 361 U.S. 304, 313 (1960); United

States v. Philadelphia National Bank, 374 U.S. 321, 348-49 (1963) ;

lVaterman Steamship Corp. v. United States, 381 U.S. 252, 269

(1965); United States v. Southwestern Cable Co., 392 U.S. 157, 170

(1968) : Brown v. United States, 192 Ct. Cl. 203, 210, 426 F.2d 355,

357 (1970): and Humble Oil & Refining Co. v. United States, 194

Ct. Cl. 920, 932, 442 F.2d 1362, 1369 (1971).

ieeteniids n ceew~. «.

ee,

D-13

Rather, I am moved by the simple fact that section 1232 fails

to deal at all with original issue discount on securities held

for no more than six months, and therefore must conclude

that the applicable rule, even under the 1954 Code, was the

“economic reality” of United States vy. Midland-Ross Corp.,

381 U.S. 54 (1965), that such discount is equivalent to

interest. Taxpayers can point to no part of section 1232

which lays down the treatment for original issue discount

on bonds held for no more than six months. Subsection (a)

(2)(A), as everyone agrees, is restricted on its face to evi-

dences of indebtedness held for more than six months; sub-

section (a)(1) is no more than the equivalent of section

117(a)(4) ot the 1939 Code which the Court in Midland-

Ross held not a bar to treating original issue discount as

ordinary income. The text of section 1232, in the initial 1954

Code, did not deal at all, as I read it, with the problem of

original issue discount on bonds retained no more than

half-a-year.

I agree with the taxpayer that the Congress which enacted

that section may well have thought that original issue dis-

count on such securities would thereafter be dealt with as

short-term capital gain. But that was because that Congress

mistakenly believed that Commissioner v. Caulkins, 144 F.2d

482 (C.A. 6, 1944)—which had held all original issue dis-

count on bonds held for investment to be capital gain—

would continue as good tax law except insofar as the rule

was changed in section 1232 for the longer-term securities.

And the probability is that that same Congress did not think

it important to change the Caulkins rule for the no-more-

than-six-months bonds because short-term capital gain is

normally taxed at ordinary income rates. (The peculiar

situation now before us does not seem to have been in any-

D-14

one’s mind.)' At any rate, it seems to me clear that the

Congress which enacted the 1954 Code did not adopt, in

section 1232 or another provision, any rule for original issue

discount on evidences of indebtedness held for no more than

six months; it simply left that subject uncovered by specific

rule. The result is that, since Congress has not imbedded

any part of Caulkins in the Code, we are required to apply

the rule of Midland-Ross which superseded and overruled

Caulkins. Congress is not legislating when, instead of lay-

ing down a statutory rule, it leaves a subject alone, even

though it may be content to let the matter be covered by a

lower-court decision which later happens to be set aside by

the Supreme Court. Cf. Helvering v. Hallock, 309 U.S.

106, 119-22 (1940).?

As for the claim of unlawful discrimination, I would rest

squarely on the ground that the taxation of non-resident

foreign taxpayers raises such different considerations that

it cannot validly be compared, for equal protection pur-

poses, to the taxation of domestic taxpayers.

1. There is no solid indication that the section 1232 Congress

affirmatively desired that original issue discount on bonds held for

no more than six months should be treated as capital gain even if

Caulkins should be overturned by the Supreme Court.

2. The views of a later Congress on the earlier law have “ ‘very

little, if any, significance.’” United States v. Southwestern Cable

Co., 392 U.S. 157, 170 (1968). Therefore weight should not be

given to the 1969 Senate report which said that “In * * * [the case

of pre-1969 corporate indebtedness and Government bonds], gain on

the sale or exchange of a bond or other evidence of indebtedness

which is a capital asset in the hands of the taxpayer but which has

not been held by the taxpayer for more than 6 months is to be treated

as a short-term capital gain as under present law.” S. Rep. No. 91-

552, 91st Cong., Ist Sess. 148 (1969) (1969—-3 Cum. Butt. 518).