Appendix — Texstar Corp. v. United States

Supreme Court brief1983

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APPENDIX A

The TEXSTAR CORPORATION, Transferee of the

assets of Unitex Industries, Inc. and its subsidiaries,

Plaintiff-Appellee,

UNITED STATES of America,

Defendant-Appellant.

No. 81-1277.

United States Court of Appeals,

Fifth Circuit.

Oct. 7, 1982.

Transferee of corporate assets and liabilities filed oom-

plaint seeking refund of federal income taxes allegedly

improperly assessed and collected. The United States Dis-

trict Ccurt for the Northern District of Texas, David O.

Belew, Jr., J., 528 F.Supp. 75, entered judgment for the

corporation, and the Government appealed. The Court of

Appeals, Thornberry, Circuit Judge, held that corporation

was not entitled to debt discount deduction based on its

exchange of debentures for all outstanding preferred stock

where market value of either debentures or stock could

not be determined.

Reversed.

John F. Murray, Acting Asst. Atty. Gen., Michael L.

Paup, William S. Estabrook, Stephen Gray, Attys., Tax

Div., Dept. of Justice, Washington, D.C., for defendant-

appellant.

Before THORNBERRY, GEE and GARWOOD, Cir-

cuit Judges.

Appeals from the United States District Court for the

Northern District of Texas.

Richard D, Walker, Fort Worth, Tex., J. Burleson

Smith, J. Michael Wilkes, San Antonio, Tex., for plaintiff-

appellee.

[1] The sole issue in this appeal is whether Texstar

Corporation is entitled to a debt discount deduction under

THORNBERRY, Circuit Judge:

§ 163(a),’ based on its exchange of debenture bonds

for all its outstanding preferred stock.

163(a) of the Internal Revenue Code of 1954, 26 U.S.C.

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The exchange of debentures for preferred stock scru-

tinized in this case was carriud out by Unitex Industries

prior to Texstar’s purchase of Unitex in 1966." Unitex

was first incorporated as I.C.T. Discount Corporation in

1952. At that time it issued both common and preferred

stock. The preferred was cumulative, participating, no-

par, non-voting stock. Each share of preferred was en-

titled to cumulative dividends of seventy-two cents per

year prior to the payment of any dividends on common

stock. And, if any dividend was paid to common share-

holders, preferred shareholders were entitled to receive

the same dividend per share. The articles of incorporation

further provided that upon liquidation of the corpora-

tion, preferred shareholders were entitled to receive twelve

dollars per share prior to any distribution on the common

2. In 1969, Congress amended the Internal Revenue Code, setting

out detailed rules governing original-issue discount in a stock-for-

bonds exchange. Tax Reform Act of 1969, Pub, L. 91-172, § 413(b),

83 Stat. 611. The relevant statute now es in pertinent part:

In the case of a bond or other lence of indebtedness, or an

cong oe kt gnglleapon: sent edie cow hk walla Sed 8

tion 368(a)(1) or an vency reorganization . . .), which is

issued for property and which—

(A) is part of an issue a portion of which is traded on an

established securities market, or

may be, shall be the fair market value of such property. Except

in cases to which the preceding sentence applies, the issue price

of a bond or other evidence of indebtedness (whether or not

issued as a part of an investment unit) which is issued for prop-

erty (other than money) shall be the stated redemption price

at maturity,

26 US.C.A. §1232(b)(2). The statute applies only to exchanges

occurring after May 27, 1969. Since the debentures in this case were

issued before 1969, the statute does not apply in this case.

stock with conditional participation in subsequent dis-

tributions. Th> preferred stock was sold door-to-door at

twelve dollars per share by representatives of Jack Cage

& Company. I.C.T. promised to pay the Cage Company

a commission of twenty per cent of the sale price of each

preferred share it sold.

LC.T. experienced severe losses in the 1950's that re-

sulted in a deficit in earned surplus of $4,346,857.56. In

1956, new management took charge of the corporation

and began a rehabilitation program, and in 1957, I.C.T.

changed its name to Unitex. The accumulated deficit

nevertheless continued to make the prospect of any divi-

dend remote. As a result, the shareholders in 1957 di-

rected the formulation of a plan to restructure the capi-

talization of Unitex in a manner satisfactory to committees

composed of common and preferred shareholders. Two

years later, the shareholders approved a plan that elimin-

ated the entire class of 126,023 preferred shares and gave

the preferred shareholders, in exchange, two dollars in

cash and a ten dollar debenture, bearing interest at the

rate of five per cent per annum, for each share they re-

retirement of at least two and one-half per cent

original issue of debentures each year. This exchange of

preferred stock for debentures also eliminated the deficit

Id. at 79. On appeal, the government argues that the dis-

trict court erred in its application of the principles set

forth in National Alfalfa and GM & O. We agree.

In National Alfalfa, pursuant to a recapitalization plan

to eliminate arrearages on preferred shares, the taxpayer

corporation required its shareholders to exchange their

$50 par 5% cumulative preferred shares for $50 face

value 5% sinking fund debentures.’ The taxpayer claimed

a discount on the difference between the fair market value

of the stock and the face amount of the debentures. After

a detailed discussion of the appropriate considerations to

be weighed by a court faced with this question, the Su-

preme Court held that the taxpayer was not entitled to

bond discount. The primary inquiry in determining

whether any bond discount exists is “whether the issuer-

taxpayer has incurred, as a result of the transaction, some

cost or expense of acquiring the use of capital.” National

Alfalfa, 417 U.S. at 147, 94 S.Ct. at 2136, The taxpayer

argued that it had incurred a $17 cost in issuing the bonds

because the $50 par preferred shares it received had an

alleged fair market value of only $33.

The Supreme Court rejected this argument, concluding

that in the absence of any actual or even attempted sales

of debentures or purchases of the preferred shares by the

taxpayer in the open market, the Court could only specu-

late as to what the market price and the investor reaction

to such events would have been. /d. at 150, 94 S.Ct. at

2137. The Court based its refusal to speculate as to the

fair market value of the bonds or the preferred shares

on three grounds.

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the entire block of preferred shares was outstanding. /d.

at 150, 94 S.Ct. at 2138. Finally, the Court recognized

that “when a corporation issues to its preferred share-

the exigencies of the competitive money market.” Id, at

151, 94 S.Ct. at 2138. Since the debentures in National

Alfalfa were not traded on the open market, and since

the taxpayer presented no other evidence of the fair

market value of the bonds at the time of their issuance,

the Court concluded that “the requisite valuation of the

property to be exchanged cannot occur in this intracor-

porate transaction and debt discount cannot be deter-

mined,” Id. (Citations omitted).

Four years later, this Court in GM & O addressed the

question of original-issue discount in the context of a

stock-for-bonds transaction. Between 1957 and 1962, the

taxpayer in GM & O redeemed approximately two-thirds

of its outstanding $100 par value 5% cumulative pre-

ferred shares in exchange for an equivalent number of

$100 face value 5% interest sinking fund bonds. Several

years after the transaction, the taxpayer unsuccessfully

applied for a tax refund based on an alleged original-

issue discount computed by subtracting the total market

value of the preferred during the exchange period from

the total principal amount of the debentures.

Rejecting the Government's claim that National Alfalfa

established an absolute prohibition against original-issue

discount when a corporation exchanges its bonds for its

own preferred stock, this Court instead applied the rule

set out in National Alfalfa that bond discount arises only

where the issuer-taxpayer incurs as a result of the trans-

action some costs or expense of acquiring the use of

capital. 579 F.2d at 896 (citing National Alfalfa, 417

U.S, at 147, 94 S.Ct. at 2136). The Court concluded that

the transaction in GM & O differed from that in National

Alfalfa in three significant respects, and awarded the tax-

payer a discount deduction measured as the difference

between the principal amount of the debentures and the

fair market value of the preferred stock determined by the

mean New York Stock Exchange price during the ex-

change period.

The Court first noted that “since the original value

received for the preferred shares was much less than the

$100 face amount of the bonds, there was an additional

cost for the use of capital.” Jd. at 898, Second, the deben-

tures in GM & O were subject to a sinking fund provision

while the preferred shares were not. Last, and most im-

portant, the stock-for-bonds exchange in GM & O “was

completely voluntary and was affected by market forces.”

a Wall Street Journal.” Id.

[2] The same cannot be said of the present case. The

debentures issued by Unitex were not traded on any

market. As in National Alfalfa, there was nothing in the

record establishing the cash price at which the debentures

could have been sold had they been offered for sale.

Texstar secks to remedy this defect by arguing that since

it offered one debenture plus $2 cash for each preferred

open market in sufficient quantity to permit the calcula-

tion of its market value. Texstar acknowledges in its brief

that its own expert witness accorded little weight to the

scattered quotations for the preferred on the over-the-

counter market, because the market was too thin. More-

over, as in National Alfalfa, there is no evidence in the

record to indicate that Unitex could have purchased all

its outstanding preferred on the open market, or at what

price that quantity of stock would have been purchased.

In its denial of a discount deduction in National Alfalfa,

the Supreme Court emphasized that the stipulated over-

the-counter quotations for preferred stock “were quota-

tions for what at most was a thin market, and were hardly

representative of the fair market value of the entire 47,059

shares outstanding.” 417 U.S. at 150, 94 S.Ct. at 2138.

Lacking a market value for its preferred stock, Texstar

instead offers the uncontradicted testimony of its expert as

10a

to the value of the preferred at the time of the exchange.‘

However, this value, like a published market value, can-

not serve as a basis for the calculation of original-issue

discount unless it can be equated with the fair market

value of the debentures. This Court in GM & O explained

that “[aJny assumption of an equivalence of the deben-

tures and the preferred is unjustified where the transaction

is insulated from the marketplace since the market forces

which normally would bring about an equivalence of the

two are absent.” 579 F.2d at 900 (citing Cities Service

Co, v. United States, 522 F.2d 1281 (2d Cir. 1974),

cert. denied 423 U.S. 827, 96 S.Ct. 43, 46 L.Ed.2d 43

(1975)). In GM & O, where the individual shareholders

relied on published market prices for both the stocks and

the bonds in deciding whether to exchange their shares,

we concluded that the transaction was “influenced by the

‘exigencies of the competitive money market.’” /d., (cit-

ing National Alfalfa, 417 U.S. at 151, 94 S.Ct. at 2138).

As a result, we were able in that case to identify and

calculate the additwwnal cost of borrowing incurred by

the taxpayer. Marke: forces acted through the participants

in that transaction to effectively demonstrate the existence

of a readily ascertainable discount. “[I]t is economically

. . « logical to assume that before deciding to trade the

preferred shareholders compared the value of their stock

to the value of the debentures in light of market prices

and their own personal preferences.” 579 F.2d at 899.

In other words, if the shareholders in GM & O knew that

one share of preferred was worth more than one debenture,

4. The basis for this estimate included those factors which the

Supreme Court in National Alfalfa suggested were essential to a

determination of the value of untraded debentures. Of course, where

the fair market value of the debentures can be directly ascertained,

any estimation of the value of the preferred is superfluous.

the preferred at the time of the trade. Since the

tion in GM & O was obligated to repay the face amount

of the debentures, the difference between that figure and

the fair market value of the debentures represented an

added cost of borrowing. Because the debentures could

have sold at par if this added cost had instead been in-

curred in the form of a higher stated annual rate of in-

terest on the debentures, the added cost could be viewed

U.S.C. § 163(a) as “interest paid or accrued within the

taxable year on indebtedness.” Only a process like this

one, that reveals the presence of discount while permitting

its calculation, can justify a finding of original-issue dis-

count in an intracorporate exchange of stock for bonds.

Nothing like this process occurred in the present case.

Here, the shares were redeemed en bloc pursuant to a

plan approved by the shareholders, as in the insulated

transaction in National Alfalfa. Nor was the exchanee

entirely free, being required by charter amendment op-

posed by a material minority of the preferred shares.’

The estimate of the value of the preferred sought to be

substituted for the fair market value of the debentures in

5. ciples aya awtbaak yale hay fry mgtie ger Progr Fa

0 ee es eee to this difficulty there

must be added not only the absence of a market (for both the pre-

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this case was reconstructed many years after the transac-

tion occurred, We are unable to perceive in this artificial

scenario the play of market forces acting through informed

agents to reveal a measurable additional cost of borrowing

money.°®

Since Texstar cannot change the history of this intra-

corporate transaction, a remand to determine the value of

either the preferred shares or the debentures would be a

pointless exercise.

REVERSED.

6. Texstar maintains that Unitex’s poor financial condition just

prior to the reorganization, and the two-year period during which the

shareholders a reorganization plan with the corporation,

furnish evidence that market forces acted on the exchange. But

speculation as to the presence of general market forces “in the air”

is a woefully inadequate substitute for the visible effect of the forces

of supply and demand in “determin{ing] objectively how much of

one [product] is worth so much of another.” 579 F.2d at 892. This

Court in GM & O held that because “the holders of preferred shares

could examine the published market prices for both the preferred and

the debentures before deciding to trade . . . the market value of the

preferred shares is a good yardstick for determining the real issue

price of the debentures.” /d. at 900. Where, as here, no market prices

were available for either the debentures or the preferred, the recon-

structed market value of the preferred cannot furnish an accurate

measure of the real issue price of the debentures.

We find little merit in Texstar’s claim that because the original

issue price of the preferred shares was less than the face amount of

the debentures, the co tion suffered a measurable cost or expense

obtaining the use of capital. In determining the amount of bond

discount, this Court in GM & O relied upon the value of the preferred

the time the bonds were issued, not the original value re-

for the stock. 579 F.2d at 901.

Although the existence of a sinking fund as an incident of the de-

bentures may offer added protection to the debenture paar Pe is

relevant only to a consideration of the fair market value of de-

bentures themselves. Since the fair market value of the debentures

cannot be directly established here, this factual distinction is of little

help in the determination of debt discount.

is not enough

to hint at the existence of discount. The existence

13a

APPENDIX B

The TEXSTAR CORPORATION, Transferee of the

assets of Unitex Industries, Inc. and its subsidiaries,

Plaintiff,

UNITED STATES of America,

Defendant.

Civ. A. No. 4-1795.

United States District Court,

N. D. Texas,

Fort Worth Division.

June 29, 1981.

Transferee of assets of corporation brought suit secking

refund of federal income taxes it alleged were wrongfully

assessed and collected. The District Court, Belew, J., held

that where original value received for each preferred share

in exchange of debentures and cash for corporation’s own

outstanding preferred stock was less than full amount of

debentures, where only debenture holders would have

advantage of a sinking fund, and moreover, market forces

acted on exchange of stock for debentures, principal

amount paid as premium for issuance of debenture was

“original issue discount” and as such was cost or expense

and under applicable section of Internal Revenue Code,

deductible interest.

Order entered.

avs

14a

Cox, Smith, Smith, Hale, & Guenther, J. Burleson Smith

and J. Michael Wilkes, San Antonio, Tex., Richard D.

Walker, Fort Worth, Tex., for plaintiff.

Kenneth J. Mighell, U. S. Atty., Ben A. Douglas, Atty.,

Tax Division, Dept. of Justice, Dallas, Tex., for defendant.

AMENDED MEMORANDUM OPINION

BELEW, District Judge.

Plaintiff, Texstar Corporation, as transferee of assets of

Unitex Industries, Inc., brings suit seeking a refund of

federal income taxes it alleges wrongfully assessed and

collected. This action involves original issue discount and

its proper valuation.

The Court makes the following findings of fact based

upon the pleadings, stipulations, and evidence elicited at

the trial.’

1. Unitex was incorporated on August 5, 1952, as

1.C.T. Discount Corporation, Its name was altered to

I.C.T, Corporation on May 11, 1955, and later changed

to Unitex Industries, on August 21, 1957. On November

15, 1966, the assets of Unitex Industries, Inc. were pur-

chased by Texstar Corporation, Plaintiff, which agreed to

assume any and all prior liabilities for additional federal

income taxes.

2. In 1952, LC.T. had both common and preferred

stock. The preferred stock, no par value, non-callable,

non-voting, was entitled to a cumulative dividend of $0.72

1. This case was tried before the Honorable Leo Brewster in

August 1972. While waiting the final decision in the principal case

cited herein, Judge Brewster became ill and passed away in 1979

without rendering Judgment,

15a

per share per annum (or six (6) percent of the $12 pur-

chase price).

3. During the period beginning January 1, 1953 and

ending December 31, 1954, LC.T. Discount Corporation

had no “earnings and profits” within the meaning of that

term as it is used in the Internal Revenue Code of 1954,

§ 316, 26 U.S.C. § 316, and no “earned surplus” as that

term is defined under Texas Business Corporations Law,

Tex. Bus. Corp. Act. Ann. art. 2.38 (1980). Illegal pay-

ments aggregating $1.49 per share, represented as divi-

dends, were distributed to the preferred shareholders dur-

ing that period.

4. During the early and mid-1950’s, poor company

management caused steep losses and resulted in a deficit

in earned surplus of $4,346,857.56. In 1956, new man-

agement took charge of the corporation and began a

program of rehabilitation.

5. On December 7, 1957, at a special meeting of pre-

ferred shareholders, a resolution was passed directing the

management of Unitex to re-structure its capital formation.

Those efforts culminated in a plan, approved by both the

preferred and common shareholders, setting forth the fol-

lowing exchange: all present outstanding preferred stock,

per share, for $2.00 cash and the issuance of a debenture,

$10.00 face value, payable in twenty (20) years, bearing

interest at the rate of five (5) percent per annum, with

a sinking fund provision of at least two and one-half

(2%) percent of the original issue debenture bonds each

year, subordinated to all other debts of the company.

This action was implemented in 1959, and had the effect

of eliminating the deficit in earnings and profits while

making a small capital surplus.

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16a

6. Plaintiff acquired the assets and assumed all liabili-

ties of Unitex, Inc. in 1966. Subsequently, an Internal

Revenue Service audit assessed deficiencies in income tax

for the years 1963, ($170,484.16 plus interest of $66,-

393.07); 1964 ($65,307.44 plus interest of $21,514.77);

1965 ($94,443.03 plus interest of $25,446.57) and the

short year January 1, 1966 through November 15, 1966

($36,326.00 plus interest of $6,739.00). Pla‘utiff paid

said tax on or about September 21, 1970, and later filed

unsuccessful claims for refunds.

7. The parties have settled and resolved their contro-

versy with respect to the allowance of the claimed bad

debt deduction, Internal Revenue Code of 1954, § 165,

26 U.S.C. § 165, which is not related to the bond discount

issue. The court hereby adopts and ratifies the parties’

agreement.

8. The fair market value of Unitex preferred stock

on December 31, 1959 was $3.99.?

Jurisdiction

Jurisdiction is founded on Title 28, U.S.C. § 1346(a)

(1) (1977).

Issues of Law

I. Did an original issue discount arise upon the issu-

ance of Unitex debentures and cash in exchange for its

own outstanding preferred stock?

II. If such discount arose, what was the proper amount?

2. See testimony of Henry Moak Rollins 80-84, but par-

ticularly as set out on pages 86-87 of the of the trial pro-

17a

Plaintiff's Complaint

Plaintiff complains Defendant has erroneously assessed

and collected federal income taxes and interest thereon

of three hundred twelve thousand, six hundred twenty-nine

and 44/100 dollars ($312,629.44). Plaintiff characterizes

the principal amount as a premium paid for the issuance

of the debenture. In effect, Texstar propounds this as an

original issue discount, represented by the difference be-

tween the fair market value of the Unitex stock and the

stated redemption value at maturity of the debenture. As

such, it is argued to be a cost or expense and under § 163

of the Internal Revenue Code, deductible interest. See

Int. Rev. Code Reg. 1.163-3(a) (1968).

Defendant's Answer

_. The Government pictures this exchange as nothing more

than a sophisticated adjustment of the corporation’s capi-

tal accounts, It contends that upon original implementa-

tion of the plan, neither the corporation nor the share-

holders anticipated this as an original issue discount.

Rather, it was a masterful, albeit unsuccessful attempt at

retroactive application of tax principles. The Government

would show the intent of the parties controls; ten (10)

percent is a reasonable discount rate; and under the facts

and circumstances of this particular case, no bond dis-

count existed because no new capital was acquired.

Discussion

I. This case is directly controlled by the definitional

analysis of original issue discount in Commissioner of

Internal Revenue v. National Alfalfa Dehydrating and

Milling Co., 417 U.S. 134, 94 S.Ct. 2129, 40 L.Bd.2d

18a

717 (1974), and by the factual application of the Na-

tional Alfalfa factors as set forth in Gulf, Mobile and

Ohio R.R. Co. v. United States, 579 F.2d 892 (Sth Cir.

1978). In an opinion by Justice Blackmun, National

Alfalfa probes with considerable depth the constructional

concept of original issue discount. It would therefore be

presumptuous for this District Court to attempt any fur-

ther explanation or clarification on such subject. Simply

stated, debt discount generally results from the sale by

an issuer of its debt obligation at an issue price below

the face amount of its obligation. The difference is re-

ferred to as the discount. Internal Revenue Code of 1954,

§ 1232(b)(1), (2), 26 U.S.C. § 1232(b) (1), (2). This

may occur whether the issuer receives cast, stock, or other

property. S. Rep. No. 91-552, 91st Cong., Ist Sess. 148

(1969); H.R. Rep. No. 91-413 (Part I), 91st Cong.

Ist Sess. 110 (1969); U.S. Code Cong. & Admin. News

1969, p. 1645; Steuben, Real Estate Planning, at 689-

691 (1974).

In National Alfalfa, pursuant to a recapitalization plan

to eliminate arrearages on preferred shares, the taxpayer

corporation required its shareholders to exchange their

$50.00 par value, 5% cumulative preferred shares for

$50.00 face value, 5% sinking fund debentures. At the

time, the preferred apparently had a fair market value

of approximately $33.00. The taxpayer claimed as dis-

count the difference between the fair market value of the

stock and the face amount of the debentures. The Tenth

Circuit opinion, finding a premium in fact did exist, held

for the taxpayer. The Supreme Court reversed, stating

as determinative, “the relevant inquiry in each case must

be whether the issuer-payer had incurred as a result of

the transaction(s), some cost or expense of acquiring the

19a

use of capital,”* Id., 417 U.S. at 147, 94 S.Ct. at 2136.

Justice Blackmun explained the transaction in National

Alfalfa as merely a swap of one form of investment for

another, identical in each insignificant feature. The face

amount of the debentures equalled the stated value of the

stock; the fixed interest on the debentures was equal to

the cumulative dividend on the preferred; and the sinking

fund provisions for both the preferred and the debentures

were comparable. The Court construed the transaction as

a resbuffling of the corporation’s capital structure, deter-

mined no additional cost was incurred in retaining the old

capital, and concluded, “. . . the substitution by NAD

[National Alfalfa Dehydrating] of its debentures for its

previously outstanding preferred, without more, did not

erase an obligation to pay in excess of an amount previ-

ously committed, or establish the base upon which debt

discount can arise,” Id., at 154, 94 S.Ct. at 2139.

Within the framework of interpreting what constitutes

original issue discount as set forth by the Supreme Court

in National Alfalfa, the Fifth Circuit in Gulf, Mobile and

Ohio R.R. Co. v. United States, 579 F.2d 892 (1978),

carved three significant distinctions which would factually

distinguish its case from National Alfalfa. In GM & O,

during 1956, the company issued 5% income debentures

to be exchanged on a voluntary basis for up to approxi-

mately 283,000 shares of GM & O’s outstanding preferred

stock. GM & O would cancel the preferred stock upon

an exchange of one income debenture in the principal

amount of $100.00 for one share of preferred stock with

3. In Notional Alfalja, the court additionally held on the facts

2la

one in National Alfalfa), we must then line up our facts

wtih the distinguishing factors in GM & O. This Court

finds an original issue discount foundationed upon the

following: (1) the original value received for each pre-

ferred share, based on all relevant criteria, was less than

the face amount of the debenture. Unitex paid a $2.40

commission on each and every share of stock sold. This

effectively reduced the amount of capital realized by the

taxpayer for the bond issue ($12.00 - 2.40 = $9.60).

Helvering v. Union Pac. R.R. Co., 293 U.S. 282, 287,

55 S.Ct. 165, 167, 79 L.Ed. 363 (1934); GM & O,

supra, 579 F.2d at 897 n.12; United States v. St. Louis-

San Francisco Ry. Co., 537 F.2d 312, 316-7 (8th Cir.

1976). In accounting terms, there was net paid-in capital

of $9.60 per preferred share. As such, Unitex incurred

an additional cost for the use of capital in the form of

a premium.

(2) As in GM & O, under the exchange offer to the

shareholders, only debenture holders would get the ad-

vantage of a sinking fund. Apparently, as earlier set out,

this was an important distinction to the Supreme Court.

This benefit negated the mere substitution of one form

for another that “did not create an obligation to pay in

excess of an amount previously committed,” National

Alfalfa, supra, 417 U.S. at 154, 94 S.Ct. at 2139. We

find it also represented an additional cost for the use of

capital.

(3) Market forces acted on the exchange of stock for

debentures. This last factor is critical and weighs most

heavily upon the facts. Unitex had been suffering through

hard times until 1957. Then, new management was in-

stalled and took charge. Great effort was made to purge

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the company of any dead weight. There was some success

in this movement, but stability was still years away. Any

long-term investment in Unitex carried a high degree of

risk. It was in this predicament the new management

approached the preferred shareholders. The corporation

could not reorganize without their approval. After two

years of negotiations, an agreement was reached.’ Each

shareholder would trade one share for $2.00 cash and a

$10.00 debenture, redeemable in twenty years. This was a

difficult choice and was reflected by the time it took to

agree. Furthermore, a promise to pay $10.00 in 1979

by Unitex was not worth $10.00 in 1959, The corporation

still possessed assets, and if liquidation occurred, they

could assert their priority status and recognize some re-

turn. Additionally, the debenture was unsecured and

subordinated to all other debt.

[1] Under these circumstances, the preferred class

voted to permit the exchange on the gamble their rela-

tively low per-share worth would in the long-run yield a

substantial gain. It is a decision investors every day make.

And it is not for the Courts to judge if there was any

more than adequate consideration passed. An important

element in the determination of National Alfalfa, easily

overlooked, is the issuer’s financial condition, including

both its credit position and profit prospects. Unitex was in

serious difficulty. It struck some hardpressed deals in

6. See National Aljalja, 417 US. at 151, 94 S.Ct. at 2138,

where Justice Blackmun cited for comparison the District Court

opinion in-GM & O v. United States, 339 F.Supp. 489 (S.D. Ala.

1972) as well as another District Court decision from within the

Fifth Circuit, Southern Fertiliser and Chem. Co. v. Edwards, 167

F.Supp. 879, 887 (M.D. Ga. 1955), in which discount was

after the parties conducted “arm’s-length negotiations” to establish

the amount of debentures and stock to be exchanged.

Pa. 4

23a

order to survive. And this distinguishes it from National

Alfalfa’s situation (a solid, going concern, attempting to

expand its eastern producing areas, 417 U.S. at 138, 94

S.Ct. at 2132) or GM & O's (saving taxes, 579 F.2d at

894). Every transaction is different. Here, Unitex paid a

premium, a high premium, in the form of interest to swing

passages of the plans. Under National Alfalfa guidelines,

Court finds this a cost or expense to Unitex. The

result of this difference was the corporation

itself to pay a debt greater in value than that

it received. It is irrelevant it reclaimed its own

securities, because they still possessed value to the cor-

poration. Consequently, any difference between this

amount and the maturity value of the bonds should be

and is treated as a discount.

(2] II. The second issue involves a computation of

the deductible discount. The amount and formula is set

forth below:

Step 1 $3.99(a)

- 2,00(b)

$1.99(c)

Step 2 $10.00(d)

- 1,99(c)

$ 8.01(e)

Legend:

(a) Fair market value of Unitex stock on December

31, 1959, as found by the Court.

(b) Cash given as part of exchange plan.

24a

(d) Stated redemption value of debenture at ma-

turity.

(e) Amount of original issue discount. From a read-

ing of National Alfalfa, GM & O, and Cities

Service, it is this Court’s determination the above

represents the correct amount of the original

issue discount." One additional point needs to

be clarified: the $2.40 as a commission. The

Court finds this an underwriting cost, and con-

sequently, irrelevant to original issue discount.

Judgment is to be entered for the Plaintiff in accord-

ance with this opinion.

AMENDED JUDGMENT

In accordance with the Memorandum Opinion entered

on this date, it is hereby ORDERED, ADJUDGED and

DECREED that Plaintiff Texstar Corporation do have

and recover of and from the United States of America

the sum of $312,629.44, as stipulated by Plaintiff, bear-

ing interest from September 21, 1970, as provided by law.

Costs are taxed against the United States of America.

IT IS SO ORDERED.

Cori sted tho meal valve of the peafarnd sharve

25a

APPENDIX C

IN THE

UNITED STATES COURT OF APPEALS

FOR THE FIFTH CIRCUIT

NO. 81-1277

D. C. Docket No. CA-4-1795

THE TEXSTAR CORPORATION,

Transferee of the Assets of Unitex Industries, Inc.

and its Subsidiaries,

Plaintiff-Appellee,

versus

UNITED STATES OF AMERICA,

Defendant-Appellant.

Appeal from the United States District Court for the

Northern District of Texas

Before THORNBERRY, GEE and GARWOOD,

Circuit Judges.

JUDGMENT

This cause came on to be heard on the record on appeal

and was argued by counsel;

ON CONSIDERATION WHEREOF, It is now here

ordered and adjudged by this Court that the judgment

of the said District Court in this cause be, and the same

is hereby, reversed;

IT IS FURTHER ORDERED that the plaintiff-ap-

pellee pay to the defendant-appellant the costs on appeal,

to be taxed by the Clerk of this Court.

October 7, 1982

ISSUED AS MANDATE: Nov. 16, 1982.

26a

APPENDIX D

IN THE

UNITED STATES COURT OF APPEALS

FOR THE FIFTH CIRCUIT

No. 81-1277

THE TEXSTAR CORPORATION, Transferee of the

Assets of Unitex Industries, Inc. and its Subsidiaries,

Plaintiff-Appellee,

versus

UNITED STATES OF AMERICA,

Defendant-Appellant.

Appeal from the United States District Court for the

Northern District of Texas

ON PETITION FOR REHEARING

(November 4, 1982)

Before THORNBERRY, GEE AND GARWOOD, Cir-

cuit Judges.

PER CURIAM:

IT IS ORDERED that the petition for rehearing filed

in the above entitled and numbered cause be and the same

is hereby denied.

ENTERED FOR THE COURT:

/s/ THOMAS GIBBS GEE

United States Circuit Judge

27a

APPENDIX E

Relevant provisions of the Tax Reform Act of 1969,

the Internal Revenue Code of 1954 and the Treasury

Regulations thereunder.

Tax Reform Act of 1969, § 413(e), Pub. L. No, 91-

172, § 143(e), 83 Stat. 487 (1970):

Effective Date.—The amendments made by this

section shall apply with respect to bonds and other

evidences of indebtedness issued after May 27, 1969

(other than evidences of indebtedness issued pursu-

ant to a written commitment which was binding on

May 27, 1969, and at all times thereafter).

LR.C, § 163(a), 26 U.S.C. § 163(a) (1978):

Interest

(a) General rule-—There shall be allowed as a

deduction all interest paid or accrued within the tax-

able year on indebtedness.

Treas. Reg. § 1.163-3(a)(1) (1968), T.D. 6984,

1969-1 C.B. 38; 26 C.F.R. § 1.163-3(a)(1) (1982):

(a) Discount upon issuance. (1) If bonds are

issued by a corporation at a discount, the net amount

of such discount is deductible and should be prorated

or amortized over the life of the bonds. For

of this section, the amortizable bond discount equals

een Ce oe payable at maturity (or, in

the case of a callable bond, at the earlier call date)

over aoe ae emer ee ee

graph (b)(2) of § 1.1232-3).

28a

Treas. Reg. § 1.1001-1(a) (1971), T.D. 7142, 1971-

2 C.B. 295, 26 C.F.R. § 1.1001-1(a) (1982):

(a) General rule. Except as otherwise provided

in subtitle A of the Code, the gain or loss realized

from the conversion of property into cash, or from

the exchange of property for other property differing

materially either in kind or in extent, is treated as

income or as loss sustained. The amount realized

from a sale or other disposition of property is the

sum of any money received plus the fair market

value of any property (other than money) received.

The fair market value of property is a question of

fact, but only in rare and extraordinary cases will

be considered to have no fair market value.

The general method of computing such gain or loss

is prescribed by section 1001 (a) through (d) which

contemplates that from the amount realized upon the

sale or exchange there shall be withdrawn a sum

sufficient to restore the adjusted basis prescribed by

section 1011 and the regulations thereunder (i.e.,

the cost or other basis adjusted for receipts, expendi-

tures, losses, allowances, and other items chargeable

against and applicable to such cost or other basis).

The amount which remains after the adjusted basis

has been restored to the taxpayer constitutes the

realized gain. If the amount realized upon the sale

or exchange is insufficient to restore to the taxpayer

the adjusted basis of the property, a loss is sustained

to the extent of the difference between such adjusted

basis and the amount realized. The basis may be

different depending upon whether gain or loss is

being computed. For example, see section 1015(a)

and the regulations thereunder. Section 1001(e) and

paragraph (f) of this section prescribe the method

of computing gain or loss upon the sale or other

disposition of a term interest in property the adjusted

basis (or a portion) of which is determined pursuant,

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LR.C. § 1232(b)(2), 26 U.S.C. § 1232(b) (2)

(1982):

30a

case of a bond or other evidence of indebtedness, or

an investment unit as <lescribed in ory oi

(other than a bond or other evidence of btedness

or an investment unit issued pursuant to a plan of

reorganization within the meaning of section 368

(a)(1) or an insolvency reorganization within the

meaning of section 371 or 374), which is issued

for property and which—

(A) is part of an issue a portion of which is

traded on an established securities market, or

(B) is issued for stock or securities which are

traded on an established securities market,

the issue price of such bond or other evidence of in-

debtedness or investment unit, as the case may be,

shall be the fair market value of such property. Ex-

cept in cases to which the preceding sentence applies,

the issue price of a bond or other evidence of in-

debtedness (whether or not issued as a part of an

investment unit) which is issued for property (other

than money) shall be the stated redemption price

at maturity.

Treas. Reg. § 1.1232-3(b) (2) (iii) (1972), T.D. 7213,

1972-2 C.B. 482; 26 C.F.R. § 1.1232-3(b) (2) (iii)

(1982):

(iii) Issuance for property after May 27, 1969—

(a) In general. Except as provided in (b) of this sub-

division, if an obligation or an investment unit is

issued for property other than money, the issue price

of such obligation shall be the stated redemption

price at maturity and, therefore, no original issue

discount is created as a result of the exchange. How-

ever, in such case, there may be an amount treated

as interest under section 483. In the case of certain

exchanges of obligations of the United States for

32a

securities market is open. For purposes of this sub-

division (iii), the term “established securities mar-

ket” shall have the same meaning as in paragraph

(d)(4) of § 1.453-3 (relating to limitations on in-

stallment method for purchaser evidences of indebt-

edness payable on demand or readily tradable).

which (b) of this subdivision applies. In general, for

purposes of (b) of this subdivision, the fair market

value of property for which an obligation or invest-

ment unit is issued shall be deemed to be the same

as the fair market value of such obligation or invest-

ment unit, determined by reference to the fair mar-

ket value of that portion of the issue, of which such

obligation or unit is a part, which is traded on an

established securities market. The fair market value

of such obligation or unit shall be determined as of

the first date after the date of issue (within the mean-

ing of section 1232(b)(3)) that such obligation or

unit is traded on an established securities market.

If, however, the obligation or investment unit is not

part of an issue a portion of which is traded on an

established securities market, but the property for

which the obligation or investment unit is issued is

stock or securities which are traded on an established

securities market, the fair market value of such prop-

erty shall be the fair market value of such stock or

securities on the date such obligation or unit is issued

for such property. The fair market value of property

for purposes of this (c) shall be determined as pro-

vided in § 20.2031-2 of this chapter (Estate Tax

Regulations) but without applying the blockage and

i special rules contained in paragraph (e) there-

.. (d) Not in reorganization, An exchange which

is not pursuant to a reorganization referred to in this

subdivision (d) is an exchange in which the obliga-

(e) Effective date. Determinations with respect to

obligations issued on or before May 27, 1969, or

pursuant to a written commitment which was binding

on that date and at all times thereafter, shall be

made without regard to this subdivision (iii).

Treas, Reg. § 20.2031-2(f) (1958), T.D. 6296, 1958-

2 C.B. 432, 480, 26 C.F.R. § 20.2031-2(f) (1982):

34a

(2) In the case of shares of stock, the 5

net worth, prospective power and

paying capacity, and other t factors,

seotiaier Bry and (2) of a pea ake

su are:

The good will of the business; the economic saa

in the particular industry; the cp ty position in

the industry and its management; degree of con-

trol of the business represented by the block of stock

to be valued; and the values of securities of corpora-

tions engaged in the same or similar lines of business

which are listed on a stock exchange. However, the

weight to be accorded such comparisons or any other

evidentiary factors considered in the determination

of a value ds upon the facts of each case. In

addition to the relevant factors described above,

consideration shall also be given to nonoperating

assets, including proceeds of life insurance policies

payable to or for the benefit of the company, to the

extent such nonoperating assets have not been taken

into account in the determination of net worth, pros-

pective earning power and dividend-earning capacity.

Complete financial and other data upon which the

valuation is based should be submitted with the

return, including copies of reports of any examina-

tions of the company made by accountants, en-

gineers, or any technical experts as of or near the

applicable valuation date.

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TABLE OF AUTHORITIES

Page

Cases:

Commissioner v. National Alfalfa Dehydrating

& Milling Co., 417 U.S. 134 ... ccc ee enes 4, 5, 6

Statutes and regulation:

Internal Revenue Code of 1954, 26 U.S.C.

Tax Reform Act of 1969, Pub. L. No. 91-172,

Section 413(b), 83 Stat. 609 ..........cceeees 6

Treasury Regulations on Income Tax

(1954 Code), 26 C.F.R. 1.163-4 ........00000. 7

Dn the Supreme Court of the Hnited States

OctToser Term, 1982

No. 82-1297

TEXSTAR CORPORATION, ETC., PETITIONER

Vv.

UNITED STATES OF AMERICA

ON PETITION FOR A WRIT OF CERTIORARI TO

THE UNITED STATES COURT OF APPEALS FOR

THE FIFTH CIRCUIT

MEMORANDUM FOR THE UNITED STATES

IN OPPOSITION

In this federal income tax case, petitioner seeks review of

the decision below denying its claimed deduction for inter-

est allegedly paid to facilitate the exchange of corporate

debentures for corporate stock. The decision turns on the

particular facts and presents no legal question warranting

review by this Court.

The pertinent facts may be summarized as follows: |.C.T.

Discount Corporation was incorporated in 1952. Its name

was altered to I.C.T. Corporation in 1955 and later changed

to Unitex Industries in 1957. The assets of Unitex were

purchased in 1966 by Texstar Corporation (Pet. App. 3a,

14a).

In 1952, 1.C.T. had issued both common and preferred

stock. The preferred was a cumulative, participating, no-

par, non-voting stock with each share entitled to cumulative

dividends of 72 cents per year prior to the payment of any

dividends on the common stock and then, if any dividend

was paid to the common shareholders, to receive the same

dividend per share that was paid to the common share-

holders. On liquidation oi the corporation, each share of

preferred stock was entitled to receive $12 prior to any

distribution on the common stock, with conditional partic-

ipation in any subsequent distributions. The preferred stock

was marketed door to door at $12 per share by salesmen

who received 20% of the sale price as commission (Pet. App.

3a-4a),

During the early and mid-1950's, 1.C.T. (later Unitex)

experienced severe losses. which resulted im a deficit in

earned surplus in excess of $4 million. In 1956, new man-

agement took charge of the corporation and began a reha-

bilitation: program. Though the new management began to

produce profits, the weight of the accumulated deficit made

the prospect of any dividend, evem on the preferred shares,

remote. With dividends. em the preferred continuing to

accrue: but going unpaid, the prospect of any return on the

common was more remote. To remedy this situation at least

in, part, management proposed to the preferred share~

holders an exchange of three shares. of common for each

share of preferred. The preferred shareholders rejected this

proposal (Pet. App. 4a,, l4a-ISa),

At a later meeting of shareholders, a resolution was

passed directing the formulation of a plam to restructure the

capitalization of Unitex in a manner satisfactory to com-

mittees of common and of preferred! shareholders. Efforts

in response to this.resolution culminated in a plan to elimi-

nate the entire class of 126,023 preferred shares and provide

the preferred shareholders with $2:cash. and a $10 debenture

for each share upon its return, The debenture was payable

in 20: years and bore interest of 5%. It was supported by a

sinking fund guaranteed to retire at least 2'4% of the origi-

nal number of debentures each year. The plan was pres-

ented and recommended to the preferred shareholders as

one that would enable them to recover the original $12

which they had invested at the expense of their right to

accrued but unpaid dividends. The plan, together with a

contemporancously adopted reclassification of the com-

mon stock, also had the effect of eliminating the earned

surplus deficit from the corporate balance sheet (Pet. App.

4a-Sa).

In this refund suit brought by petitioner in the United

States District Court for the Northern District of Texas,

petitioner sought a refund based on the theory that Unitex

incurred interest expense of $8.01 for each share of pre-

ferred stock acquired from the debenture holders. The basis

of petitioner’s claim was as follows: It asserted that Unitex

obligated itself to redeem each debenture ultimately at a

cost far in excess of the fair market value of that debenture,

deemed an equivalent to the value of property received in

exchange. Thus, petitioner claims that the “package” which

Unitex offered to procure each share of preferred stock, i.e.,

a $10 debenture and $2 cash, exceeded the value of a pre-

ferred share received in exchange. In petitioner's view, the

alleged difference between the $10 debenture and $2 cash on

the one hand, and the fair market value of a preferred share

on the other, was “interest,” or “bond discount,” charged by

a preferred shareholder for entering into the exchange trans-

action. Because there was no separate market for the de-

bentures (Pet. App. 9a), petitioner proposed that the fair

market value of the debenture-cash package be equated

with the fair market value of a preferred share. Once the

latter value could be ascertained, petitioner argued that any

difference in values is deductible interest or discount. Peti-

tioner asserts that the value of a preferred share was $3.99

on the date of the exchange. Thus, it claims an interest

deduction of $8.01 ($12 less $3.99) for each of the 126,023

preferred shares acquired via the debenture-cash package.

The district cou.. upheld petitioner's claim (Pet. App.

23a-24a). The court of appeals reversed. Adhering to this

Court's decision in Commissioner v. National Alfalfa

Dehydrating & Milling Co., 417 U.S. 134 (1974), the court

of appeals concluded that the essential elements in the

measure of bond discount were lacking in this case. As the

court analyzed the transaction, there was no trading of

preferred stock on any market to establish its fair market

value. The $3.99 value proposed by petitioner was predi-

cated on an estimate by an expert witness who, it admitted,

“accorded little weight to the scattered quotations for the

preferred on the over-the-counter market, because the

market was too thin” (Pet. App. 9a-10a). In these circum-

stances, the court of appeals concluded that where the

preferred shares were “redeemed en bloc pursuant toa plan

approved by the shareholders [but ‘opposed by a material

minority of the preferred shares’, as in the insulated trans-

action in National Alfalfa,” it was “unable to perceive in this

artificial scenario the play of market forces acting through

informed agents to reveal a measurable additional cost of

borrowing money,” which would be demonstrated where

“market prices were available for either the debentures or

the preferred” (Pet. App. 10a-12a & n.6).

1. The decision below correctly held that Unitex was not

entitled to any bond discount deduction arising out of the

exchange of its debentures and cash for the preferred stock.

In Commissioner v. National Alfalfa Dehydrating & Mill-

ing Co., supra, the controlling decision on the question

presented, this Court emphasized that “implicit in the con-

cept of debt discount is the assumption, and indeed the

requirement, that the transaction be subject to the exi-

gencies of the competitive money market” (417 U.S. at 151).

iif i aa

5 -

The Court further noted (id. at 150) that “when a corpora-

tion issues to its preferred shareholders its own new debt

obligations in exchange for outstanding preferred, the

claimed fair market value of both securities is somewhat

artificial since the exchange is effectively insulated from

market forces by the intracorporate and private nature of

the transaction.” Thus, the Court denied an interest deduc-

tion for bond discount in National Alfalfa because neither

the debentures nor the preferred shares were traded on an

open market; “{a]ccordingly, the requisite evaluation of the

property to be exchanged cannot occur in this intracorpo-

rate transaction and debt discount cannot be determined.”

Id. at 151.

2. Petitioner attacks the decision below on three grounds:

(1) the preferred stock must be presumed to have some

ascertainable value (Pet. 7-10); (2) the negotiations between

the preferred and common shareholder are tantamount to

market forces (Pet. 10-13); and (3) it is discriminatory to

require trading on a national, published market (Pet.

13-17).

While the Unitex preferred stock probably had some

value, it does not follow that such value is ascertainable

with the precision necessary to sustain a deduction for bond

discount. Indeed, in National Alfalfa, supra, 417 U.S. at

149, the Court refused, “{iJn the absence of any actual or

even attempted sales of debentures or purchases of the

preferred * * * in the open market, * * * to speculate as to

what the market price and investor reaction * * * would

have been” had the entire block of debentures and preferred

shares been actively traded on the market.

Nor do the negotiations between the preferred and com-

mon shareholders support petitioner's claim because those

negotiations were tailored only to return to the preferred

shareholders their original $12 investment (Pet. App. 4a).

There is no evidence in the record that the relations between

the preferred and common shareholders in this case were

more instrumental in establishing the respective “values” of

a debenture and a preferred share than were the relations

between the preferred and common shareholders in Nation-

al Alfalfa.

Moreover, petitioner mischaracterizes the scope of the

decision below. The court of appeals only required, in

accordance with National Alfalfa, that there be trading on

some market to establish value (Pet. App. 9a). It did not

insist, as petitioner suggests (Pet. 15 n.10), that there be

trading on a national exchange. That holding is in accord

with the Commissioner’s position, quoted selectively by

petitioner (Pet. 10), which stated that (quoting 81-1277

Appellant Reply Brief 5):

We do not argue that the bonds and preferred shares

must be traded on a national exchange before bond

discount can arise, as Texstar suggests * * *. We note,

rather, that some significant voluntary purchases of

both securities by outside, unrelated parties must occur

before value can be ascertained, and those purchases

must establish more than the thin market that the

Supreme Court in National Alfalfa held should be

disregarded. * * *

Finally, as petitioner acknowledged in its brief in the

court of appeals (Appellee Brief II), the decision is of dimin-

ishing administrative significance. Section 1232(b)(2) of the

Internal Revenue Code of 1954 (26 U.S.C.), as added by

Section 413(b) of the Tax Reform Act of 1969, Pub. L. No.

91-172, 83 Stat. 609, determines the existence of original

issue discount to a bondholder, and is effective with respect

to bonds or other evidences of indebtedness issued after

May 27, 1969 (other than evidences of indebtedness issued

pursuant to a written commitment which was binding on

May 27, 1969, and at all times thereafter). Treasury Regula-

tions on Income Tax (1954 Code), 26C.F.R. 1.163-4 makes

the same provisions applicable to the issuing corporation.

Hence, this legislation resolves the question for debentures

issued after May 27, 1969.

It is therefore respectfully submitted that the petition for

a writ of certiorari should be denied.

Rex E. Lee

Solicitor General

Maxkcu 1983

DOJ-1983-03

This is a copy of a public record, reproduced as it was published. It is not legal advice, and it may not be the version a court would rely on. Check the official source before you cite it.