Petition for Writ of Certiorari — Real Estate Investment Trust of America v. Commissioner

Supreme Court brief1965

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Office-Supreme Court, US.

. FiLED

Ary ;

: OCT 26 Wes

eiPRE? gRT. U. Se

SOHN F, DAVIS, CLERK

Supreme Court of the United States.

OctosER TERM, 1964.

No. 6 2 0

REAL ESTATE INVESTMENT TRUST OF AMERICA

ET AL.,

Petitioners,

COMMISSIONER OF INTERNAL REVENUE,

Respondent.

PETITION FOR A WRIT OF CERTIORARI TO THE

UNITED STATES COURT OF APPEALS FOR THE

FIRST CIRCUIT.

Henry Hixon Meyer,

53 State Street,

Boston, Massachusetts 02109,

Cuar.zs D. Post,

84 State Street,

Boston, Massachusetts 02109.

Counsel for Petitioners.

Of Counsel:

Wauter G. Van Dorn,

RacKEMANN, Sawyer & Brewster,

53 State Street,

Boston, Massachusetts 02109,

JosHuA M. Berman,

Goopwin, Procter & Hoar,

84 State Street,

Boston, Massachusetts 02109.

ALDISON C. GETCHELL & SON, INC., LAW PRINTERS, BOSTON.

Table of Contents.

Opinions t 2low

Jurisdiction

Question presented

Statute involved

Statement of the case

Reasons for the allowance of the writ

Appendix A

Opinion of the United States Court of Appeals

Judgment

Opinion of the Tax Court of the United States

Appendix B

Statutes involved

Aprendix C

Conflicting opinions

Table of Authorities Cited.

CasEs.

Caulkins, George Peck, 1 T.C. 656

C. I. R. v. Caulkins, 144 F. 2d 482

C. I. R. v. Morgan, 272 F. 2d 936

Dixon v. United States, 333 F. 2d 1016

Lubin v. C. I. R., 335 F. 2d 209

Old Colony Railroad Co. v. C. L. R., 284 U.S. 552

8n.

5. t, On.

3, 0, 6, 7

6n.

Opinion of the U.S. Cireuit Court of Appeals, 334

F. 2d 986

Pattiz v. United States, 311 F. 2d 947

1, dn.

Sn.

ii TABLE OF AUTHORITIES CITED

Rosen v. United States, 288 F. 2d 658 8n.

United States v. Harrison, 304 F, 2d 835 8n.

United States v. Midland-Ross Corporation, —F. 2d

(July 29, 1964) 3, 4, 3, 7, Sn.

Statutes, Etc.

In. ernal Revenue Code of 1954, 26 U.S.C.

§ 1221 2

§ 1222(3) 9

§ 1232 8n.

26 U.S.C. $$ 6213, 6214, 7442, 7482 3n.

28 U.S.C. § 1254(1) 9

Supreme Court of the United States.

Ocroper Term, 1964.

No.

REAL ESTATE INVESTMENT TRUST OF AMERICA

ET AL., ~

Petitioners,

COMMISSIONER OF INTERNAL REVENUE,

Respondent.

PETITION FOR A WRiT OF CERTIORARI TO THE

UNITED STATES COURT OF APPEALS FOR THE

FIRST CIRCUIT. |

Petitioners pray that a writ of certiorari issue to review

the judgment of the United States Court of Appeals for

the First Circuit entered in the above-entitled case on July

28, 1964.’

Opinions Below.

The opinion of the Court of Appeals is reported at 334

F. 2d 986, and is sei forth in Appendix A hereto, infra,

‘The petiticners are Real Estate Investment Trust of America.

a trust organized under the laws of the Commonwealth of Massa-

chusetts, end its seven trustees, O. Kelley Anderson, John H.

Gardiner, Charles Segal, Philip H. Theopold, Franeis C Welch,

Robert S. Fifield and Henri Bourneuf. All the petitioners and

predecessor trusts and trustees are hereinafter collectively referred

to as petitioner.

p. 11. The opinion of the Tax Court of the United States

is reported at 40 T.C. 921 (1963), and is reprinted in Ap-

pendix A hereto, infra, p. 20.

Jurisdiction.

The judgment of the Court. of Appeals was entered on

July 28, 1964 (R. 132). The jurisdiction of this Court is

invoked under 28 U.S.C. § 1254(1).

Question Presented.

Whether gain realized on the sale of a debt obligation

previously acquired at a discount is taxable as ordinary

income or as capital gain.

Statute Involved.

The statutory provisions involved are sections 1221 and

1222(3) of the Internal Revenue Code of 1954, 26 U.S.C.

§§ 1221, 1222(3), set forth in Appendix B heret+ infra,

p. 27.

Statement of the Case.

In 1948 the petitioner participated in the refinancing of

a financially distressed debtor. The debtor, a real-estate

trust owning an office building in downtown Boston, was in

default to an institutional lender for more than $4 million

on notes secured by first mortgages on its real and personal

properties. Under threat of foreclosure, the following ar-

rangement was entered into: (1) petitioner paid $500,000

and agreed to pay an additional $200,000 to the lender;

(2) the lender reduced the amount of the debtor’s obligation

to it by more than $1 million, to $3 million: and (3) the

debtor issued to petitioner its new note for $1 million se-

cured by second mortgages on the debtor’s properties.

The new note bore interest of $40,000 per annum, pay-

able quarterly, representing an effective rate of interest of

8% per annum on the amount paid by petitioner. The in-

terest was paid when due and was taxable when received as

ordinary inesme. After several extensions of its maturity

date, the note was sold by petitioner in 1958 to a third per-

son for $270,000 more than its unrecovered cost. The note

was a capital asset in the hands of petitioner. Petitioner re-

ported the $270,000 gain on the sale of the note for federa!

income tax purposes as a long-term capital gain.

The Commissioner of Internal Revenue determined that

the $270,000 gain realized was taxable as ordinary income.

The Tax Court upheld the Commissioner ;? the Court of

Appeals affirmed.’

Reasons for the Allowance of the Writ.

1. The decision of the court below is in direct contlict

with the decision of the United States Court of Appeals for

the Sixth Cireuit in United States v. Midland-Ross Corpo-

ration, F. 2d (July 29, 1964), reprinted in

Appendix C hereto, infra, p. 29, and with the decision of

the United States Court of Appeals for the Second Cireuit

in Lubin v. C. 1. R., 335 F. 2d 209 (July 27, 1964), reprinted

in Appendix C hereto, infra, p. 49.

*The jurisdiction of the Tax Court of the United States was

based on 26 U.S.C. §§ 6215, 6214 and 7442.

°The jurisdiction of the United States Court of Appeals for the

First Circuit was based on 26 U.S.C. § 7482.

Each of the three Cireuit Courts dealt with the question

whether gain realized on the sale of a debt obligation pre-

viously acquired upon original issue at a discount is tax-

able as ordinary income or as capital gain. The First Cir-

cuit below held that such gain is taxable as ordinary income.

The Sixth Circuit, reaffirming its earlier decision in C. J. R.

v. Caulkins, 144 F. 2d 482 (1944), held that it is taxable

as capital gain. ‘The Second Circuit held that the gain may

be taxable as srdinary income or as capital gain depending

upon the facts of the particular case,

The basis for the Sixth Circeuit’s view is that where a debt

obligation, such as a bond or note, is a capital asset, gain

on the sale of such an obligation falls within the statutory

definition of capital gain.

The reasoning underlying the decision of the court be-

low and other decisions in conflict with Caulkins and Mid-

land-Ross is that, where in a Joan transaction a borrower

undertakes to pay a principal sum that is greater than the

amount it has received, the excess of the principal sum

over the amount received (7.e., the original issue discount)

represents compensation for the use of the money borrowed

during the term of the loan. When, upon sale of the obliga-

tion, the holder realizes an amount (over and above his

cost) equal to all or a portion of this excess, this amount is,

under these decisions, held to be taxable as interest income

even though it is an amount that is realized upon the sale

of a capital asset.

The First Cireuit in this ease in effect held that, since

original issue discount ‘‘often’’ represents compensetion

* Throughout this petition it is assumed, as in fact it was in the

instant ase, that the debt obligation sold was a capital asset in the

hands oc the seller. In some eases, such as those where the seller

deals in the purchase and sale of debt obligations in the ordinary

course of his business, a debt obligation is not considered to be a

capital asset ; gain on the sale of such an obligation is always taxable

as ordinary income.

for the use of money borrowed, gain on the sale of an orig-

inal issue discount obligation is, as a matter of law, taxable

as ordinary income. Whether, on the one hand, the obliga-

tion bears a fair rate of interest apart from the discount,

or whether, on the other haad, the discount is an obvious

substitute for interest was said to be ‘‘of little signifi-

cance.’’®

This rigid view was urged ur on the United States Court

of Appeals for the Second Cireuit and rejected in Lubin.

The Second Cireuit, like the First Circuit, is in direet con-

flict with the Sixth Cireuit’s decision in Midland-Ross.

The Second Circuit has held that gain realized on the sale

of an original issue discount obligation is taxable as ordi-

nary income where the discount represents an interest

equivalent. Dizon v. United States, 333 F. 2d 1016

(June 19, 1964). However, the Second Circuit and the

First Cireuit are in conflict with one another on whether

gain realized on the sale of a debt obligation acquired upon

original issue at a discount is always to be treated as in-

terest income and taxable as ordinary income. The First

Circuit held that such is the rule as a matte: of law. The

Second Cirevit in Lubin reversed a memorandum decision

of the Tax Court, T.C. Memo. 1963-292, and held that the

gain may be taxable as ordinary income or as capita! gain

depending upon the facts of the particular case—that the

transaction giving rise to the obligation must be ** reduced

to its essentials’’ in order to determine whether the dis-

count in substance represents compensation for the use of

5**TIn an attempt to distinguish the cases repudiating Caulkins,

petitioner refers to the fact that the discount in those eases was an

obvious substitute for interest while here the obligation bore a sub-

stantial, fair, independent rate of interest. That fact is of little

significance, however, since original issue discount is often in the

nature of additional interest which accrues over the life of the in-

strument and is payable at maturity of the principal obligation.”

334 F. 2d 986, 990, infra, p. 17.

money borrowed or whether it represents a potential specu-

iative profit.

‘*The Commissioner would have us rule that any-

thing above face value paid on notes by an obligor

must, as a matter of law, be regarded as interest, no

matter what the substance might be of the underlying

transaction which has given rise to the obligations. . .

‘*. .. As the Code does not require a profit realized

in this form to be treated as interest, and as the evi-

denee relating to the substance of the transaction

afforded no basis upon which the Tax Court could have

concluded that these profits were interes: payments,

we hold that ¢ 1232(a)(1) should be applied in ac-

cordance with its terms so that petitioners will be

taxed at capital gains rates.’’ 335 F. 2d 209, 213, infra,

pp. 56, d8.

This Court has defined interest within the meaning of

the revenue laws as follows:

‘* .. ‘{I|nterest’ means what is usuaily called in-

terest by those who pay and those who receive the

amount so denominated in bond and coupon .. . the

words of the statute ...do not refer to some eso-

teric coneept derived from subtie and theoretic an-

alysis.’’®

When the transaction in the instant ease is reduced to

its essentials, it becomes clear that the discount invoived

did not represent an interest equivalent. Immediately

before the 1948 refinancing, the debtor was in default to

an institutional lender for more than $4 million on notes

®Old Colony Railroad Co. v. C. IT. R., 284 U.S. 552 (1932), at

p. 561.

secured by mortgages on its real and personal properties.

R. 28. The lender insisted on a substantial reduction in

the debtor’s obligation to it. R. 28. The refinancing ar-

rangement was entered intv under threat of forecioszre.

R. 23, 39.

The transaction giving rise to the new obligation was in

effect an assignment by the lender to petitioner at a dis-

count of the portion of the lender’s claim against the

debtor in exeess of $3 million. The new $1 millicn note is-

sued to petitioner was issued in consideration of the dis-

charge of a portion of an antecedent debt owed by the

debtor to the lender. R.29. Upon issuance of the new note,

the debtor received its full principal amount (in fact, more)

by the reduction of its indebtedness to the lender by more

than $1 million. R. 29, 30. The new note issued te peti-

tioner bore interest of $40,000 per annum, payable quar-

terly, representing an effective rate of interest of 8% per

annum on the amount psid by petitioner. R. 29. On these

facts it is clear that the discount represented not an interest

equivalent as it did in Dixon, but rather a potential profit

as in Lubin.

The Court is asked to resolve the conflict among the Cir-

cuits either in favor of the view of the Sixth Circuit that

gain ou the sale of a debt obligation acquired at a discount

is taxable as capital gain, or in tavor of the view of the

Second Circuit that gain on the sale of such an obligation

may be taxable as ordinary income or as capital gain de-

pending upor all the facts and circumstances of the par-

ticular case.

Petitioner dues not know whether the United States will

petition for a writ of certiorari to review the Sixth Circuit’s

decision in Midland-Ross, or whether the United States

will seek certiorari to review the Second Cireuit’s decision

in Lubin. The taxpayer has sought certiorari to review

the Second Cireuit’s decision in Diavon. Docket No. 486.

2. The questions presented in this case are of substan-

tial importance in the administration of the internal rev-

enue laws.

The federal income tax treatment of gain realized on the

sale of original issue discount obligations has long been

unsettled. In 1943 the Tax Court in Caulkins held that gain

realized on the sale of such obligations was taxable as capi-

tal gain.’ In 1944 the Commissioner of Internal Revenue

announced that he acquiesced :a this decision.® It was not

until ten years later, in 1955, that the Commissioner re-

versed his position and withdrew his acquiescence.’ Since

then this issue has been litigated in five Cireuit Courts of

Appeals!’ and the Court of Claims," resulting in the con-

flict among the Cireuits herein noted.

The reported cases suggest that a great many debt ob-

ligations involving substantial sums were issued in the

form of original issue discount obligations during the ten-

year period when the Commissioner’s published acqui-

escence in Caulkins was outstanding. Undoubtec!y, a great

many of these obligations have yet to be disposed of."

? George Peck Caulkins, 1 T.C. 656 (1943).

®°C.B. 1944, p. 5.

9 C.B. 1955-1, p. 7.

The First Cireuit; Second Cireuit, Dixon, supra; Third Cir-

cuit, Rosen vy. Un'ted States, 288 F. 2d 658 (1961); Fifth Circuit,

United States v. Harrison, 304 F. 2d 835 (1962); Sixth Cireuit,

Midland-Ross, supra; and Ninth Circuit, C. 1. R. v. Morgan, 272

F. 2d 936 (1959).

1 Pattiz v. United States, 311 F. 2d 947 (1963).

12 Section 1232 cf the Internal Revenue Code of 1954 provides

a statutory rule with respect to the sale or retirement of debt ob-

ligations of corporations, governments or political subdivisions

thereof issued after December 31, 1954. The new statutory rule

does not apply to the sale or retirement of debt obligations issued

during the ten-year period 1944 to 1954, while the Commissioner ’s

published acquiescence in Cauikins was outstanding. Nor does the

new s.atutory rule apply to debt obligations of individuals, part-

nersuips aud other non-corporate persons.

The Commissioner has given no relief to taxpayers who

acted in reliance on his announced position on this issue.™

This itself raises the question whether the courts should

sanction such a departure from the fair administration of

ihe revenue laws. In any event, it is all the more reason

why the confliet among the Circuits herein noted ought to

be resolved in this Court.

For the foregoing reasons, this petition for a writ of

certiorari siould be granted.

Respectfully submitted,

HENRY HIXON MEYER,

CHARLES D. POST,

Counsel for Petitioners.

13 The debt obligation sold in this case was aequired by petitioner

in 1948, during the ten-year period of the Commissioner’s an-

nounced acquiescence in Caulkins.

Appendix A.

Opinion of the United States Court of Appeals.

(334 F. (2d) 986 (1st Cir., 1964).]

Unitepv States Court or APPEALS

For THE First Circuit

No. 6288.

Rea Estate INVESTMENT TRUST

oF AMERICA ET AL.,

PETITIONERS,

CoMMISSIONER OF INTERNAL REVENUE,

RESPONDENT.

ON PETITION FOR REVIEW OF THE DECISION OF THE

TAX COURT OF THE UNITED STATES

140 T.C. 921]

Before Wooprury, Chief Judge, and Hartican

and Avpricn, Circwt Judges.

Edward C. Thayer and Walter G. Van Dorn, with whom Racke-

mann, Sawyer & Brewster was on brief, for petitioners

Carolyn R. Just, Attorney, Department of Justice, with whom

Louis F. Oberdorfer, Assistant Attorney General, and Lee A.

Jackson and Josepk Kovner, Attorneys, Department of Justice,

were Gc: brief, for respendent.

OPINION OF THE CouRT.

July 28, 1964.

Hartican, Cercuit Judge. This is a petition for review of

a decision of the Tax Court entered on October 21, 1963.

Appendix A--Opinion of Court of Appeals

The petitioners are Real Kstate Investment Trust of

America and its seven trustees but for purposes of this

appeal only the Trust will be referred to, and that as

petitioner.

The facts have been stipulated. In 1948 Boston Chamber

of Commerce Realty Trust (hereinafter Realty Trust) was

in arrears to the Prudential Insurance Company in the

amount of $3,500,000 unpaid principal borrowed between

1922 and 1925 io finanee Realty Trust’s erection of a down-

town office building. The loans were represented by two

Realty Trust notes secured by a first and second mortgage

m the property, a first mortgage on certain personal

property within the office building and an assignment of all

rents from the building. There was also owing to Pru-

dential by Realty Trust over $500,000 unpaid interest on

the two notes.

In an attempt to achieve a substantial reduction in Realty

Trust’s debt, on May 12, 1948 Realty Trust, Prudential and

Boston Real Estate (hereinafter Boston) entered into a re-

financing arrangement whereby Realty Trust agreed to

execute and deliver to Prudential an extension agreement

acknowledging that the principal then owed to Prudential

was $3,000,000. Realty Trust also agreed to execute and

deliver to Boston a note dated May 12, 1948 in the face

amount of $1,000,000 at 4 pereent interest to mature on

September 26, 1952 and secured by a second mortgage on

the real estate, a second mortgage on the personal pronerty

within the building and a secondary assignment of the office

building’s rents. On its part, Boston agreed to pay, and

Prudential agreed to aecept, $500,000 and $200,000, without

interest, on September 26, 1952 as substitution for and in

satisfaction of that portion of Realty Trust’s overdue debt

(both principal and interest) in excess of $3,000,000. Pru-

dential discharged its second mortgage on the real estate.

Appendix A—Opinion of Court of Appeals

The $1,000,000 note had no interest coupons »er was if at

any time in registered form. It carried with 1 provision

for prepayment of the face amount in whole or in part at

any time. The note was acquired by petitioner in November

of 1955 when Boston and several other trusts were, through

the medium of a tax free exchange, consolidated into pe-

titioner. The note was assigned to petitioner which suc-

ceeded to and acquired Boston’s basis in the note.

On September 26, 1952 by agreement between Prudential,

Realty Trust and Poston the maturity date of the note was

extended to September 26, 1957. A further extension of

the maturity date to September 26, 1959 with interest in-

creased to 6 percent, was agreed to by Realty Trust, Pru-

dentia) and petitioner upon the arrival of the September

1957 date.

On September 30, 1958, Realty Trust entered into an

agzreement for the sale of its land and office building to the

Federal-Franklin Trust subject to the mortgages held by

Prudential and petitioner and subject to the entry of a

decree by the Suffolk County Probate Court approving such

sale. Following the court’s approval the sale was com-

pleted and the property actually conveyed on December 30,

1958 for $559,000 subject to the mortgages.

On November 25, 1958, the petitioner sold the note of

May 12, 1948, which at this time had an unpaid principal

balance of $749,053.41, for $719,053.41 to Fifty Associates, a

Massachusetts corporation. ‘The sale was a bona fide trans-

action. As of the date of the sale Realty Trust had paid to

petiti. ner and its predecessor $250,946.59 of principal on

the note thereby reducing petitioner’s basis in the note to

$449,053.41. In addition, Realty Trust had paid the interest

specified in the note, as amended. Petitioner received on

Appendix A—Opinion of Court of Appeals

the sale of the note $270,000 in excess of its basis in the

note. The note was a capital asset in the hands of peti-

tioner and on the date of its sale had been held bv the pe-

titioner for more than six months.

A few days prior to the completion of the sale of the

land anc building, the prospective purchaser, Federal-

Franklin Trust, requested Fifty Associates, the purchaser

of the note from petitioner, to accept payment thereon.

Fifty Associates agreed and on December 30, 1958, the note

was paid by Federal-Franklin Trust.

On its income tax return for the taxable year ended

May 31, 1959, petitioner reported the ameunt received in

excess of its basis in the note ($270,000) as long-term

capital gain. Tus respondent determined that the gain

realized by petitioner on the sale of the note was taxable

as ordinary income. In its decision the Tax Court held

that the gain realized from the sale was, in fact, interest

in the form of an original issue discount and taxable as

ordinary income. A deficiency was assessed in petitioner’s

income tax in the amount of $72,900.

Petitioner relies on the case of Commissioner of Internal

Revenue v. Caulkins, 144 F. 2d 482 (6th Cir. 1944) to sup-

port its contention that original issue discount is not ordi-

nary income in the nature of interest but is instead capital

gain. It argues that since the note constituted a canital

asset held for more than six months a gain resulting fom

its bona fide sale is governed by the tax provisions of sec-

tion 1222(3) of the Int. Rev. Code of 1954.'

1Sec. 1222. OrTnHer Terms RELATING To CapiITaAL GAINS AND

LOSSEs.

For purposes of this subtitle—

(3) Long-term Capital Gain.—The term ‘‘long-term capital

gain’’ means gain from the sale or exchange of a capital asset

held for more than 6 months... .

Appendix A—Opinion of Court of Appeals

In Caulkins, the taxpayer, pursuant to a contract with

Investors Syndicate, received upon retirement of the ‘‘ Ac-

cumulative Installment Certificate’? an amount above the

aggregate payments made by him. The Sixth Circuit found

the excess amount to constitute interest and held the inter-

est taxable at capital rates. The court read the then appli-

cable statute, section 117(f) of the Int. Rev. Code of 1939,

as containing a special definition of capital gains, applicable

to all amounts received upon retirement of a corporate

bond, including interest. This decision, however, has not

gone unchallenged and attempts by later taxpayers to rely

on it in seeking to have original issue discount treated as

capital gain have been largely unsuccessful. The courts

have either limited Caulkins to its facts, e.g., Warner A.

Shattuck, 25 T.C. 416 (1955); F. Rodney Paine, 23 T.C. 391

(1954), rev’d on other grounds, 236 F.2d 398 (8th Cir. 1956),

or have repudiated it outright. E£.2., Pattiz v. United

States, 311 F. 2d 947 (Ct. of Cl. 1963); United States v.

Harrison, 304 F. 2d 835 (Sth Cir. 1962), cert. denied, 372

U.S. 934 (1963) ; Rosen v. United States, 288 F. 2d 658 (3rd

Cir. 1961) ; C.I.R. v. Morgan, 272 F. 24 936 (9th Cir. 1959) ;

but see Midland-Ross Corporation v. United States, 214 F.

Supp. 631 (N.D. Ohio 1963). In view of the reason ad-

vanced by petitioner for its reliance on Caulkins,’ the de-

cisi-- of the court in Dixon v. United States, 224 F. Supp.

358, 361 (1963), aff’d (2d Cir. June 19, 1964), is especially

pertinent:

2 Petitioner finds Caulkins ‘‘in point because it dealt with a tax-

able gain on a disposition (whether on redemption or on sale) of

a capital asset. And the decision that the gain on such a disposi-

tion, whether on redemption or (as in our case) by sale, was tax-

able as a capital gain is conclusive authority on a sale under the

plain wording of Section 1222(3) as in our case.”’

Appendix A—Opinion of Court of Appeals

‘“The [Tax Co rt and Sixth Cireuit] in Caulkins

failed to realize that the gain realized from the aeemed

sale of a capital asset which has appreciated in value is

capital gain, whereas, gain realized by income from the

capital asset is ordinary income. The court, in other

words, considered both the capital asset and the in-

erement by way of interest or discount together and

considered the combined amount as a capital gain.’’

In light of the above cited decisions, we think it obvious

that Caulkins cannot be considered as the weight of au-

thority as to the tax treatment of original issue discount.

3B Mertens, Law of Federal Income Taxation § 22.40.

Rather, that case seems to have been an exception to the

general rule that amounts received from original issue dis-

counts are treated as ordinary income. See Jaglom v.

C.I.R., 303 F.2d 847, 849 (2d Cir. 1962). Original issue dis-

count is a form of interest or compensation for the use of

money. See American Smelting d Refining Co. v. United

States, 130 F.2d 883, 885 (3rd Cir. 1942). As such, it is

taxable as ordinary income under Section 61(a) of the

1954 Code.* Ordinary income cannot be corverted into

capital gain by any sale or exchange of the right to the in-

come, either separately or in conjunction with the property

producing the income. Commissioner v. P. G. Lake, Inc.,

356 U.S. 266 (1958); Hort v. Commissioner, 313 U.S. 28

3“<Sec. 61 Gross INcomME DEFINED.

(a) General Definition —Except as otherwise provided in this

subtitle, gross income means all income from whatever source de-

rived, including (but not limited to) the following items:

(4) Interest;

Appendix A—Opinion of Court of Appeals

(1941); Tunnell v. United States, 259 F.2d 916 (3rd Cir.

1958).

In an attempt to distinguish the cases repudiating Caul-

kins, petitioner refers to the fact that the discount in those

cases wus an obvious substitute for interest while here the

obligation bore a substantial, fair, independent rate of in-

terest. That fact is of little significance, however, since

original issue discount is often in the nature ot additional

interest which accrues over the life of the instrument and

is payable at maturity of the principal obligation. American

Smelting & Refining Co. v. United States, supra, at 885 and

authorities cited therein.‘

As an alternative argument, petitioner contends that .0o

original issue discount at all was involved but that the

difference between the $1,000,000 face value of the note and

the $700,000 which Boston paid for it was ‘‘market dis-

count for the embarking of funds in a hazardous oper-

ation.’’ As pointed out by the Tax Court, evidenc~ ‘n the

record does not establish that the discount reflected any-

thing other than compensation for the use of money loaned.

The fact that the note was acquired in a three party re-

financing arrangement and that the money was paid directly

to Prudential rather than to Realty Trust does not mean

that petitioner’s predecessor did not make a loan to the

maker of the note. It was a borrower-lender arrangement

with the note evidencing an ordinary type of loan, secured

by mortgages on real and personal property as well as by

an assignment of rents.

4The obligation in United States v. Harrison, supra, was a second

mertgage note which carried both a stated interest rate and an

original discount. See also V. David Leavin, 37 T.C. 767 (1962)

where the debentures in issue carried stated interest rates and

original discounts.

Appendix A—Opinion of Court of Appeals

In his deficiency notice the Commissioner stated that the

gain was taxable as ordinary income but id not state that

the reason for this was that the gain constituted interest.

The Tax Court assumed such a determination had been

made and gave it the benefit of a presumption, placing upon

petitioner the burden of showing ‘‘that its realized gain

is attributable to something other than interest.’’ We do

not, however, believe that petitioner was untairly preju-

diced by this. The case was tried on the basis of a stipu-

lation which included the statement that the pariies were

pot in agreement as to whether the amount received on ine

sale of the note should he characterized ‘‘as capital gain,"

as ordinary income, as interest or otherwise. ... ,’’ thus

showing petitioner’s awareness of the Commissioner’s po-

sition at the time the case was heard. In addition, pe-

titioner does not claim the benefit of any new evidence which

would strengthen its position were the case returned to the

Tax Court. Hay v. Commissioner of Internal Revenue, 145

F.2d 1000, 1007-1008 (4th Cir. 1944). As we have already

stated, based upon the record and stipuiation before us,

the court reached the correct result.

Judgment will be entered affirming the decision of the

Tax Coure.

Appendix A—Judgment of Court of Appeals

Untrep States Court or APPEALS

For tHe First Circuit

No. 6288.

Reat Esrate INVESTMENT TRUST oF AMERICA ET AL,

PETITIONERS,

CoMMISSIONER OF INTERNAL REVENUE,

RESPONDENT.

Judgment

July 28, 1964.

This cause came on to be heara on petition for review of

a decision of the Tax Ceurt of the United States, and was

argued by counsel.

Upon consideration whereof, Jt is now here ordered, ad-

judged and decreed as follows: The decision of the Tax

Court is affirmed.

By the Court:

/s/ Roger A. StincHrieLtp

Clerk.

Appendix A—Opinion of Tax Court

Opinion of the Tax Court of the United States.

(40 T.C. 921, 1963.)

ReaL Estate [xvestmMent Trust oF Amer:ca, O. KELLEY

ANDERSON, JoHN H. Garptner, CHARLES Secar, Prine H.

THeopotp, Francis C. Wetcu, Ropertr S. Firretp anp

Henri Bovurnevr, Trustvees, Petrrioner, v. CoMMISSIONER

’ ’ ’

or INTERNAL REVENUE, RESPONDENT

Doeket No. 91582. Filed September 4, 1963.

Petitioner's predecessor in interest acquired an interest-bearing

$1 million promissory note at a eost of $700,000. Prior to maturity

petitioner sold the note and realized a gain of $270,000. Held,

the gain so realized was, in fact, interest and was taxable as ordi-

nary income notwithstanding the fact that the transaction resulting

in the realization of such gain was a sale.

Edwerd C. Thayer, tor the petitioner.

J. Frost Walker, Jr., for the respondent.

OPINION

Fay, Judge: Respondent determined deficiencies in peti-

ticuer’s income tax for the taxable years ended May 31,

1959, and May 32, 1960, in the amounts of $120,707.29 and

$26,325.38. respectively. The only issue’ remaining for

decision ‘s whether all or a part of the gain realized upon

the sale of a promissory note which was originally aequired

at a discount by the selier constitutes interest taxable as

ordinary income.

‘In its petition to this Court, petitioner did not place in issue

respondent’s adjustments for the fiscal year ended May 31, 1960,

and with the exception of the above-stated issue did not eontest

respondent’s other adjustments for the taxable year ended May

31, 1959.

Appendix A—Opinion of Tax Court

All of the facts have been stipulated and are found ac-

cordingly.

Real Estate Investment Trust of America (hereinafter

referred to as petitioner) was created in 1955 by the con-

solidation of the Boston Real Estate Trust (hereinafter

referred to as Boston) and several other trusts. Boston

was organized in 1886 under the laws of Massachusetts and

until the time of its consolidation with other trusts into

the petitioner was engaged in the ownership and manage-

ment of improved business real estate in Boston, Mass.,

and elsewhere.

Petitioner at all times has kept its records and filed its

income tax returns on a eash receipts and disbursements

fiscal year basis ending May 31. For the taxable year

ending May 31, 1959, petitioner filed its Federal income tax

return (Form 1120) with the district director of internal

revenue at Boston, Mass.

During the years between 1922 and 1925 the Boston

Chamber of Commerce Realty Trust (hereinafter referred

to as Realty Trust) erected an office building in Boston,

Mass. In addition to the funds raised by the sale of its

capital stock, Realty Trust made two borrowings from the

Prudentia! Insurance Co. of America (hereinafter referred

to as Prudential). The first borrowing in the amount of

$3,660,000 was evidenced by a note dated September 26,

1922, and was secured by a first mortgage on the property.

The second borrowing in the amount of $400,000 was evi-

denced by a note dated June 11, 1925, and was secured by

a second mortgage on the property. In 1937 Realty Trust

executed and delivered to Prudential 2 first mortgage on

certain personal property contained ‘» the office building

as further security for the two notes. In 1940 F.zalty Trust

executed and delivered to Prudential! an assignment of all

Appendix A—Opinion of Tax Court

rents from the office building as further security for the

two notes.

As of May 12, 1948, there was overdue and unpaid the

prineinal sum of $3,500,000 and in excess of $500,000 of

unpaid interest on the two notes. As a result, Prudential

insisted upon a substantial reduction in such indebtedness.

On May 12, 1948, Boston, together with Prudential and

Realty Trust, entered into a refinancing arrangement. The

gist of the arrangement was (i) that Realty Trust was to

execute and deliver to Prudeutial an extension agreement

which acknowledged that the principal sum then owed to

Prudential was $3 million; (2) that Realty Trust as maker

was to execute and deliver to Boston as payee a note dated

May 12, 1948, in the face amount of $1 million which was to

bear interest of 4+ percent per annum and was to mature

on September 26, 1952; (8) that Boston was to pay to Pru-

dentiat $500,000 and to deliver to Prudential an agreement

to pay an additional $200,000 without interest on September

26, 1962; (4) that Prudential was to accept the payment of

$500,000 and the agreement of Boston to pay $200,000 at a

later date in substitution for and satisfection of that por-

tion of the indebtedness (both principal and interest) then

due by Realty Trust to Prudential! in exeess of $3 million:

(5) that Prudential was to discharge its second mortgage

of real estate dated June 11, 1925: (6) that as seeurity for

the $1 million note Boston was to receive a second mortgage

on the real estate, a second mortgage on the personal

property contained in the office building, and a secondary

assignment of the rents from the office building.

The $1 million note dated May 12, 1948 (hereinafter re-

ferred to as the Boston note), and delivered to Boston pur-

suant to the above arrangements at no time had interest

coupons and was ai no time in registered form.

Appendix A—Opinion of Tax Court

By the maturity date of the Boston note, i.e., September

26, 1952, Realty Trust had paid to Boston $113,198.49 of

principal, thereby reducing Boston’s basis in such note from

$700,000? to $586,801.51. In addition, as of September 26,

1952, Realty Trust had paid to Bostun the 4 percent interest

specified in said note.

On September 26, 1952, an agreement was entered into

among Realty Trust, Boston, and Prudential extending the

maturity date of the Boston note to September 26, 1957.

During the mouth of November 1955 Boston and several

other trusts were, through the medium of a tax-free ex-

change and reorganization, consolidated into the petitioner.

By virtue of such reorganization, the Boston note was

transferred to petitioner and petitioner sueceeded vo and

acquired Boston’s basis in the note.

By the extended maturity date of September 26, 1957,

Realty Trust had paid to petitioner and its predecessor,

Boston, $223,816 of principal on the Boston note, thereby

reducing petitioner’s basis in such note to $476,184. In

addition, Realty Trust had made the interest payments

specified in the note.

On September 26, 1957, an agreement was entered into

among Realty Trust, Prudential, and petitioner further

extending the maturity date of the note to September 26,

1959, and increasing the interest from 4 percent to 6 per-

cent.

On September 30, 1958, Realty Trust entered into an

agreement for the sale of its land and office building to the

Federal-Franklin Trust subject to the mortgages heid by

Prudential and petiticner and subject to the entry of a de-

eree by the Suffolk Sounty Probate Court approving such

2 Cash payment of a esaenes plus indebtedness of $200,000.

Appendix A—Opinion of Tax Court

sale. Following a hearing before the Probate Court on

November 5, 1958, a sales price of $559,000 for the equity

subject to the two mortgages was authorized. The sale was

completed and the property actually conveyed on December

30, 1958.

On November 25, 1958, the petitioner sold the Boston

note, which at this time had an unpaid principal balance of

$749,053.41, for $719,053.41 to Fifty Associates, a Massa-

chusetts corporation. The sale was a bona fide transaction.

As of the date of the sale Realty Trust had paid to peti-

tioner and its predecessor $250,946.59 of principal on the

note thereby reducing petitioner’s basis in the note to $449,-

053.41. In addition, Realty Trust had paid the interest

specified in the Boston note, as amended. Petitioner re-

ceived on the sale of the Boston note $270,006 in excess of

its basis in the note. The Boston note was a capital asset in

the hands of petitioner and on the date of its sale had been

held by the petitioner for more than 6 months.

A few days prior to the completion of the sale of the land

and building, the prospective ~urchaser, Federal-Franklin

Trust, requested Fifty Associates, the purchaser of the Bos-

ton note from petitioner, to accept payment of the Boston

note. Fifty Associates agreed to accept payment and on

December 30, 1958, the boston note was paid by Federal-

Franklin Trust.

On its income tax return for the taxable year ended May

Us, 195%, petitioner reported the amount received in excess

of its basis in the Boston note ($270,000) as long-term cap-

ital gain. The respondent determined that the gain realized

by petitioner ou the sale of the Boston note was taxable

as ordinary income.

The cnly issue presented for our consideration is whether

the gain realized by petitioner upon the sale of the Boston

Appendix A—Opinion of Tax Court

note is taxable at ordinary income or capital gains rates.

The respondent determined that the difference between the

petitioner’s basis in the Boston note and the face value of

such note (adjusted to the price at which it was sold just

before maturity) was interest in the form of an original

issue discount. Such being the case, the respondent con-

tends thai the gain is taxable as ordinary income.

Petitioner contends that since the Boston note was a cap-

ital asset held for more than 6 months and since the sale

was a bona fide transaction the taxability of the realized

vain is governed by the provisions of section 1222(3) of

the Internal Revenue Code of 1954.°

It is now the generally accepted rule that a right to re-

ceive ordinary income produced by a capital asset is not

transmuted into a capital asset by the sale or exchange

of the capital asset together with the right to receive the

ordinary income. Twunnell v. United States, 259 F. 2d 916

(C.A. 3, 1958) ; Rosen v. United States, 288 F. 2d 658 (C.A.

3, 1961); United States v. Harrison, 304 F. 2d 835 (C.A. 5,

1962) ; Fisher v. Commissioner, 209 F. 2d 513 (C.A. 6, 1954),

affirming 19 T.C. 384 (1952), certiorari denied 347 U.S. 1014

(1954); Jaglon v. Commissioner, 303 F. 2d 847 (C.A. 2,

1952), affirming 36 T.C. 126 (1961); Commissioner v. Mor-

gan, 272 F. 2d 936 (C.A. 9, 1959), reversing 30 T.C. 881

(1958); Richard B. Gibbons, 37 T.C. 569 (1961). Conse-

quently, petitioner’s reliance upon section 1222(3) of the

1954 Code is misplaced i’, in fact, any part of the gain real-

3Sec. 1222. OrHer Terms RELATING TO CAPITAL GAINS AND

LossEs.

For purposes of this subtitle—

(3) LONG-TERM CAPITAL GAIN.—The term ‘‘long-term capi-

tal gain”” means gain from the sale or exchange of a capital

asset held for more than 6 months, * * *

Appendix A—Opinion of Tax Court

ized upon the sale of the Boston note is attributable to a

right to receive ordinary income. The respondent’s de-

termination is, of course, presumptively correct and the

burden is upon the petitioner to show that its realized gain

is attributable to something other than interest. F. Rod-

ney Pawne, 23 T.C. 391 (1954), reversed on other grounds

236 F. 2d 398 (C.A. 8, 1956)..

The record discloses that the petitioner’s predecessor

acquired the Boston note ($1 million face value) at cost of

$700,000, thereby receiving an original issue discount of

$300,000. In the absence of evidence to the contrary, orig-

inal issue discounts are usually treated as additional com-

pensation for the ase of the lender’s mouey. F’. Rodney

Paine, supra; L. Lee Stanton, 34 T.C. 1 (1960); Richard B.

Gibbons, supra; Rosen v. United States, supra; United

States v. Harrison, supra. See also American Smelting &

Refining Co. v. United States, 130 F. 2d 883, 885 (C.A. 3,

1942). Compensation for the use or forbearance of money

is interest, Deputy v. duPont, 308 U.S. 488, 498 (1940) ;

Charles T. Fisher. 19 T.C. 384 (1952), affd. 209 F. 24 515

(C.A. 6, 1954), and ineludable in gross income under section

61(a) (4) of the 1954 Code. Since there is no evidence in

the record to support a finding that the discount in this case

reflected elements or factors having no relation to interest,

the conclusion is inescapable that the gain realized by peti-

tioner upon the sale of the Boston note was essentially

compensation for the use of its money. Accordingly, re-

spondent’s determination with respect to this issue is sus-

tained.

Decision will be entered under Rule 50.

Appendix B—Statutes Involved

Appendix R.

Statutes Involved.

INTERNAL REvVENVE CoDE or 1954.

Sec. 1221. Caprrat Asser Derinep.

For purposes of this subtitle, the term ‘‘capital asset’’

means property held by the taxpayer (whether or not con-

nected with his trade or business), but does not include—

(1) stock in trade of the taxpayer or other property

of a kind which would properly be included in the in-

ventory of the taxpayer if on hand at the close of the

taxable year, or property held by the taxpayer pri-

marily for sale to customers in the ordinary course of

his trade or business;

(2) property, used in his trade or business, of a

character which is subject to the allowance for de-

preciation provided in section 167, or -eal property

used in his trade or business;

(3) a copyright, a literary, musical, or artistic com-

position, or similar property, held by—

(A) a taxpayer whose personal efforts created

such property, or

(B) a taxpayer in whose hands the basis of such

property is determined, for the purpose of deter-

mining gain from a sale or exchange, in whole or in

vart by reference to the basis of such property in the

hands of the person whose personal efforts created

such property;

(4) accounts or notes receivable acquired in the

ordinary course of trade or business for services ren-

Appendix B-—Statutes Involved

dered or from the sale of property described in para-

gaph (1); or

(5) an obligation of the United States or any of its

possessions, or of a State or Territory, or auy political

subdivision thereof, or of the District of Columbia,

issued on or after March 1, 1941. on a discount basis

and payable without interest at a fixed maturity date

not exceeding one year from the date of issue.

Sec. 1222. Oruer Terms Rextatinc to Caprrat (fAINS AND

LossEs.

For purposes of this subtitie—

(3) Lone-TExm capiTaL Gain.—The term ‘‘long-term

capital. gain’’ means gain from the sale or exchange

of a capital asset held for more than 6 months, if and

to the extent such gain is taken into account in com-

puting gross income.

Appendix C—Conflicting Opimions

Appendix C.

(Conflicting Opinions)

No. 18524

[ F. (2d) , (6th Cir., 1964).]

Unirep States Court or APPEALS

For THe Srxtu Crrecuir

Mtpia.:-Ross Corporation, On <AppeaL from the

Plaintiff-Appellee, United Staies Dis-

Vv. trict Court, North-

Usirep States or AMERICA, ern District of Ohio,

Defendant-A ppellant. Eastern Division.

Decided July 29, 1964.

Before: Wetcx, Chief Judge, Cectz, Cireuit Judge, end

McAuuister, Senior Cireuit Judge.

Per Curtam. This cause is before the Court on appeal

from a judgment of the United States District Court for

ihe Northern District of Ohio granting judgment in favor

of the appellee, a taxpayer, againsi the United States, the

appellant. The sole question presented on the appeal is

whether original discount income received upon the sale

of notes prior to their maturity is entitled to be treated as

capital gains under Section 117(f) of the Internal Revenue

Code of 1939.

Appendix C—Conflicting Opinions

Jadge Kalbfleisch of the District Court wrote a compre-

hensive opinion in the case in which he followed the ruling

of this Court in Commissioner of Internal Revenue v.

Caulkins, 144 F. 2d 482. While some courts! have taken a

contrary view on the issue presented we are of the opinion

that the Caulkins case, controlling in our circuit, was cor-

rectly decided.

The pertinent facts are stated in the opinion of the Dis-

trict Court reported at Midland-Ross Corp. v. United

States, 214 F. Supp. 631. We agree with the opinion of

Judge Kalbfeisch and the judgment of the District Court

is affirmed.

[214 F. Supp. 631 (N.D. Ohio, 1963).]

Mipitanv-Ross Corporation, Plaintiff,

Unirep States of America, Defendant.

Civ. A. No. 36411.

United States District Court

N. D. Ohio, E. D.

March 11, 1963.

Kaxsreiscnu, District Judge.

This is a suit to recover income and excess profits taxes

for the years 1952, 1953 and 1954. The taxpayer is the Mid-

land-Ross Corporation, successor in interest to the Indus-

trial Rayon Corporation. During the period in question,

1 Dixon v. United States, — F. 2d —, C.A. 2; Pattitz v. United

States, 311 F. 2d 947, Ct. Cl.; United States v. Harrison, 304 F. 2d

835, C.A. 5, cert. den., 372 U.S. 934; Rosen v. United States, 288

F. 2d 658, C.A. 3; Commissioner v. Morgan, 272 F. 2d 936, C.A. 9.

Appendix C—Conflicting Opinions

for the purpose of temporarily investing funds not then cur-

rently required for its operation, tae taxpayer purchased

thirteen notes, the face amounts of which varied from

$500,000 to $2,000,000. These notes bore no interest, but

rather were purchased at a discount by the taxpayer from

the maker. Each of the notes was a time instrument.

Before maturity each note was sold te a financial insti-

tution at a price which was in excess of the price which had

been paid to the maker but below the face amount.

The price paid by the taxpayer to the maker of each note

was calculated by subtracting from the face amount a

figure determined by multiplying the face amount by an

agreed percentage, dividing the product by 360, and auaulti-

plying the result by the number of days from the date of

such payment to the maturity of ’.° note. The agreed

percentage was determined on the b~ sis of the considera-

tion of several factors, including (1) tne prevailing interest

rates for notes of such duration made by borrowers with

credit standings of the obligor, (2) the availability of such

notes to prospective purchasers, and (3) the maker’s need

for cash funds. All of the notes were capital assets in the

hands of the taxpayer and were sold by it i bona fide sales.

In negotiating the sale price of the notes, the following

factors were considered: (1) the face amounts of the ob-

ligations, (2) the credit rating of the obligor, (3) the period

of time between the sale and the maturity of the notes,

(4) the prevailing interest rates, and (5) the amount of

eash funds available to the purchaser.

In this three-year period the taxpayer realized a total

appreciation of more than $280,000 on these notes. It con-

tended that this appreciation was a capital gain. while

the Internal Revenue Service contended that it was regular

income. The taxpayer paid taxes at the regular income

rate, and is here seeking a refund.

Appendix C—Conflicting Opinions

The relevant sections of the Internal Revenue Code are:

Section 117(a) (1) (2) and (4) and Section 111(a) of the

1939 Code, and their counterparts in the Code of 1954.

Section 117(a) (1) of the 1939 Code defines a capital asset

as: ;

‘<* * * preperty held by the taxpayer (whether or not

connected with his trade or business), but does not in-

a? ==

‘*(D) an obligation of the United States or of any

of its possessions, or of a State or Territory, or any

political subdivision thereof, or of the District of Co-

lumbia, issued on or after March 1, 1941, on a discount

basis and payable without interest at a fixed maturity

date not exceeding one year from the date of issue.’’

Subsections (2) and (4) of Section 117(a) provide that a

capital gain is a gain from the sale of a capital asset, and

Section 111(a) provides that the gain from the disposition

of property is the ‘‘excess of the amount realized therefrom

over the adjusted basis * * *.’’

Plaintiff stresses the fact that the language of the stat-

ute. especially of Section 117(a) (1) defining a capital as-

set, is broad and sweeping. It contends that because these

notes were capital assets the gain realized thereon was a

capital gain. It contends, further, that in view of Section

117(a) (1) (D), which specifically excludes certain types of

discount paper from the category of capital assets, and in

view of the failure to exclude such paper as these notes, the

Congress clearly indicated its intention that the gain

achieved on the sale of suck notes constitutes capital gain

uuder the maxim of expressto untus est exclusto alterius.

Appendix C—Conflicting Opinions

[1] The taxpayer’s contention is e familiar enough gen-

eral rule of statutory construction. However, various

courts have read certain exceptions into this statute. They

have held that, while it might appear that a literal construe-

tion of the statutory language would convert all but the

specifically excluded gains into capital gains, the provisions

must be construed in the light of their general purpose and

che surrounding law. After so uoing, these courts have

read further exceptions inte the statute, which have re-

sulted in the exclusion from capital gains treatment of cer-

tain increments wuich a literal interpvetaticn might ‘ndi-

cate were capital gains. Sve, for example, Jaglom v. Com-

missioner, 303 F.2d 847 (2nc. Cir., 1962); United States v.

Harrison, 304 F.2d 835 (5th Cir., 1962). In view of the fuet

that these statutory sections have not been interpreted to

j~elude all of the transaciions which the sweeping scope of

their language might indicate were within their purview,

the Court is constrained to hold that this argument is not

dispositive of the case.

The Government contends that the realized increment

was in fact interest paid for the use of money, and was

therefore regular income to the taxpayer. it contends that

this is but another instance tor application of the well

r. xognized rule that when a taxpayer combines the sale

of a right to receive ordinary income with the sale of a

capital asset the ordinary income i; not converted inte a

capital gain by its sale in combination with the capital asset.

Fisher v. Commissioner, 209 F.2d 513 (6th Cir. 1954),

cert. den. 347 U.S. 1014, 74 S.Ct. 868, 98 L.Ed. 1136; Com-

missione: v. Morgan, 272 F.2d 936 (9th Cir., 1959) ; Rosen

vy. United States, 288 F.2d 658 (3rd Cir., 1961); United

States v. Harrison, 304 F.2d 835 (Sth Cir. 1962); and

United States v. Langston, 308 F.2d 722 (5th Cir., 1962).

Appendix C—Conflicting Opinions

The taxpayer does not dispute the general validity of

this proposition. Its principal contention, however, is that

the rule is inapplicable on these facts because the incre-

ment, for purposes of taxation at least, was not interest.

It fully admits that if these notes had borne interest at a

stated rate, and if it had then sold such notes before ma-

turity at an increase in price, the amount of such increase

allocable to the proportion of the interest earned to the

date of sale wouid have been reguiar income under the rule

of Fisher v. Commissioner and the other cases cited, supra.

However, it contends that a different result is achieved

when, instead of the notes bearing interest at a fixed rate,

they were originally sold at a discount. The taxpayer urges

that there has been a continuous history of legislative, ad-

ministrative and judicial interpretation since 1920 which

has consistently held that original issue discount in the

hands of a cash basis taxpayer is not income, and that the

appreciation resuiting therefrom is not taxed as regular

income but, rather, as a capital gain.

{2} If it is true that historically the law has not con-

sidered such original issue discount as interest, but has

removed it from the broad category of regular income and

placed it within the specific classification of capital gain,

then the increment in this case was not income and the gen-

era! rule upon which the Government relies is inapplicable.

The Court, therefore, must proceed to examine the treat-

ment which such discount has traditiona!!y received.

Commissioner v. Caulkins, 144 F.2d 482 (6th Cir., 1944)

is the primary cornerstone upon which the taxpayer rests its

contention that the increment here involved was not, for tax-

ation purposes at least, compensation for the use of its

money. In that case the taxpayer had purchased an ac-

cumulative installment certificate under the terms of which

Appendix C—Conflicting Opinions

he was to make periodic payments to the seller, who, at the

end of ten years, would pay to the taxpayer the sum of

$20,000. This $20,000 was approximately $4,900 more than

the total amount of the payments made to the seller. The

Commissioner contended that this $4,900 was compensa-

tion for the use of the taxpayer’s money, and was thus

really interest. He held that this interest was regular in-

come, although the taxpayer contended it was a capital gain.

The certificate involved in the Caulkins case was in regis-

tered form and the decision was based upon an interpreta-

tion of Section 117(f) of the Internal Revenue Code of

1939. Section 117(f) provided that amounts received by

the holder ot registered securities upon their retirement

should be considered as amounts received in exchange

therefor. The Court held that although the $4,900, at least

in many respects, was similar to interest, it was an amount

which was received in exchange for the sale of a capital

asset and was therefore a capital gain.

To understand the Caulkins decision it is neeessary to

understand the history of Section 117(f). Before the en-

actment of that section it had been held that retirement of

a bond was not such a sale or exchange as would qualify the

amount received upon the retirement for capital gains treat-

ment. See Fairbanks v. United States, 306 U.S. 436, 59

S.Ct. 607, 83 L.Ed. 855 (1939). Section 117(f) was enacted

to avoid this holding. It provided that amounts received

upon the retirement of certain evidences of indebtedness

which had interest coupons attached, or which were in reg-

istered form, should be considered as amounts received in

exchange therefor. This provision enabled the amounts

received upon the retirement of such bonds to qualify as

capital gains. The taxpayer contends that this provision

was enacted to accord the same tax treatment to such bonds

Appendia C—Conflicting Opinions

upon their retirement as always had been accorded them on

a sale before retirement. And, according to Mertens Law

of Federal Income Tax, Volume 38, page 368, M 82:

‘“‘The purpose underlying the enactment of Section

117(f) of the 1989 Code was to azcord to the retirement

of obligations similar treatment as was then, and is now,

accorded to their sale or exchange.”’

In view of the purpose of Section 117(f), it appears that

before the passage of that section amounts received upon

the sale of such evidences of indebtedness did qualify for

capital gains treatment. If a sale before maturity of such

obligations did not permit increments to be accorded capital

gains treatment, it is unlikely that the Congress would

have deliberately enacted a provision according them such

favorable treatment upon retirement.

From the combination « ‘his legislative history with the

Caulkins decision it is possible to draw the following an-

alogy: Section 117(f), under the Caulkins holding, pro-

vided that all amounts received in exchange for the retire-

ment of a qualifying capital asset were capital gains. Be-

cause Section 117(f) was meant to be declaratory of the

pre-existing law on sales before retirement, it follows

that all amounts received on the pre-retirement sale of

such debt obligations were likewise capital gains. The

validity of this analogy must be tested by a further inauiry

into legislative, administrative and judicial history. How-

ever, befvre proceeding with that history it is necessary to

examine the Government’s position as to what the Caulkins

case really heid.

The Government contends that Caulkins was based solely

upon an interpretation of Section 117(f). It says that the

crucial fact in Caulkins was not that the debt obligations

Appendix C—Conflicting Opinions

were discount obligations but that a retirement rather than

a sale was involved. It has thus attempted to convince the

Court that the Caulkins decision does not control this case,

because in the present instance the notes were sold before

maturity, rather than retired. It is true that the opinion

in the Caulkins case primarily discusses the retirement

factor; however, the Court is not convinced that increments

on debt obligations which qualify under Section 117(f)

would be accorded capital gains treatment if the obliga-

tions were retired, but would be taxed at reguiar income

rates if they were sold before maturity. Even the Tax

Court, which adopted that position in Paine v. Commis-

sioner, 23 T.C. 391 (1954), Rev. 236 F.2d 398 (8th Cir.,

1956), and Stanton v. Commissioner, 34 T.’. 1 (1960), has

now abandoned such a distinction. Gibbons v. Commis-

sioner, 37 T.C. No. 57. The purpose of Section 117(f)

surely was uot to accord a more favorable tax treatment

to income realized upon retirement of debt obligations than

it would receive if they were sold before maturity. The

quotation from Mertens, supra, also clearly indicates that

such was not the case. Therefore. this Court is constrained

to hold that the crucial fact in the Caulkins case was that

the evidences of indebtedness were discount obligations.

The combination of the Caulkins case with Section 117(f)

thus indicates that appreciation realized on evidences of in-

debtedness, issued at an original discount and sold before

maturity, constituted a capital gain and not regular income.

The remaining question, therefore, is whether the legisla-

tive, administrative and judicial treatments of discount ob-

ligations support this indication.

The earliest administrative decision upon this matter

which has been furnished to the Court is Office Decision

1024 published in Vol. 2, Cum.Bul. 189 (1920), holding that

Appendix C—Conflicting Opinions

original issue discount on bonds was not interest and,

therefore, was not subject to special withholding provisions

when the bonds were in the hands of foreign corporations.

It is true, as the Government contends, that this opinion was

not concerned with whether an appreciation resulting from

such discount was a capital gain or regular income. It was

concerned, however, with whether such gain was in faci in-

terest. The opinion carefully examined the various factors

involved and came to the conclusion that original issue dis-

cornt, while in some ways like interest, differed from in-

terest in other respects and was in fact not interest.

The writers appear to have been agreed that in the period

following 1920 a taxpayer could not accrue bond discount,

but had to report ali of it in the year in which it was re-

ceived. No part of the discount was allowed to be treated

as income prorated over the life of the bond. See Ac-

countant’s Handbook, 2d Ed., p. 339 (1932); Newlowe, In-

termediate Accounting, p. 205 (1939); and 4 Mertens Law

of Federal Income Taxation, Section 23.162, p. 298. How-

ever, this well established rule does not meet the real issue

in question, which is whether the income, in the year in

which it was reported, was treated as a capital gain or as

regular income. There is, however, one case from this

period which again reiterates the fact that discount is not

interest. That case is Corn Exchange Bank v. Commis-

sioner, U. 8. Board of Tax Appeals, 6 B.T.A. 158 (1927).

Taxpayer had sought to amortize bond discount and pre-

mium. The Board of Tax Appeals refused to allow such

amortization. In doing so, it said, at page 161:

‘‘The discount on the bond purchased below par is unlike

interest, which is a fixed charge and accrues periodically.

The right to receive this ciscount, or difference between

Appendia C—Corjiicting Opinions

the cost of the bond and its par, cannot be determined in

advance as the bond may be sold for more or less than its

cost, or, perhaps, as in the ease of many bonds, it may be

redeemed prior to its maturity at an amount different

from its principal or face amount of the bond. This dis-

count is not earned or accrued in annual installments and

cannot be income to the holder of the bond, either as addi-

tional interest or as a separate item of income.”’

The Government contends that the Corn Exchange Bank

opinion was dealing only with regular discount as distin-

guished from original issue liscount. It fully agrees that

discount which is the result of such factors as an obligor’s

default in interest payments does not give rise to ordinary

income. However, an examination of both the facts and the

opinion in the Corn Exchange Bank case fails to reveal that

the Court there was discussing any particular kind of dis-

count. <A practical examination of the transactions in-

volved leads the Court to conclude that it is extremely likely

that both kinds of discount were involved.

This case indicstes that during the 1920’s the Depart-

ment of Internal Revenue, which prevailed in the Corn Ex-

change Bank decision, had co’ ' ended that discount was not

interest. And if discount was not interest, income resulting

from discount could not have been taxable at regular rates

on the premise that it was interest.

In 19406 the Internal Revenue Service held that income

realized from the redemption of state discourt bonds was

interest, and, accordingly, was non-taxable. G.C.M. 21890,

1940-1, Cum.Bul. 85. It said the courts had considered the

nature of discount and found it to be like deferred interest.

Such discount was, in effect, payment for the use of the

money lent. The vaiue of this ruling is questionable, how-

Appendix C—Conflicting Opinions

ever, because it necessarily involved statutory and consti-

tutional limitations upon the federal taxation of state

bonds. And while the ruling held that such discount was

like interest, it carefully avoided holding that it was in-

terest. Thus, at least until 1940, and possibly thereafter,

the Internal Revenue Service held that discount was not

interest. The legislative treatment of bond discount should

be viewed against this administrative background.

In 1929 the Congress authorized the Treasury Depart-

ment to issue non-interest-bearing discount obligations.

The bill authorizing these notes, as passed by the House

and as approved by the Senate Finance Committee, con-

tained a provision that, as to profits attributable to the

discount, ‘‘any gain from the sal> or other disposition

thereof shall be exempt from all taxation.’’ Congressional

Record, Senate, June 4, 1929, p. 2319. This provision for

tax exemption met with considerable opposition upon the

floor of the Senate, because the Senators believed such

profits were capital gains, and feared that such a provision

would open the way for the future exemption of all capital

gains fron. .axation. Several members of the Senate en-

gaged in a lengthy debate about the relationship between

original issue discount and interest, and the tax conse-

quences that flowed therefrom. That debate indicates that

at least some members of the Senate belicved that original

issue discount was in fact a substitute for interest; but

thc.* who purported to be familiar with the subject pointed

out that, under the then current practice of the Bureau of

Internal Revenue, income attributable to original issue

discount was treated as a capital gain and not as regular

income. See page 2331, Congressional Record, supra. The

question was finally resolved by the insertion of a provision

in the bill that amounts received as the result of original

Appendix C—Conflicting Opinions

issue discount on these notes would be called interest, thus

bringing them within the already existing interest exemp-

tion Likewise, a similar provision was added as an amend-

ment to the Second Liberty Bond Act of 1917, Title 31

U.S. C.A. § 757e(d). Thus, the legislative history indicates

that appreciation resulting from this discount was statu-

torily transformed into interest to avoid its taxation as a

capita! gain. |

These facts further substantiate the taxpaver’s conten-

tion that during the period of the 1920’s and early 1930's

original issue discount was not considered interest, but

rather gave rise to a capital gain. Furthermore, the Cong-

ress was aware of this construction and acquiesced therein

by failing to statutorily change the rule until 1954. See

Section 1232(a) (2) (A), Internal Revenne Code of 1954.

This section now provides that, upon the sale or exchange

of evidences of indebtedness issued by a corporation cr a

government, amounts of appreciation a*tributable to orig-

inal issue discount will not be considered as gains resulting

from the sale or exchange of a capital asset. In other

words, in 1954, and governing evidences of indebtedness

issued after the ones which are now before this Court, the

Congress stated that appreciation resulting from original

issue discount would henceforth be considered as regular

income and not as capital gain. |

The House report accompanying this section stated that

under existing law such gains were taxed as capital gain-

if the bond was held to retirement, and that this section was

enacted to change that rule insofar as appreciation r--ult-

ing from original issue discount was concerned. 3 U.S.

Code Congressional and <Acministrative News, 1954,

p. 4110. The report of the Senate Finance Committee is

less helpful. It merely stated that ‘‘There is some uncer-

Appendix C—Conflicting Opinions

tainty as to the status of proceeds in these transactions, i. e..

as capital gain or as interest income where tae bond or

other evidence of indebtedness has been issued at a discount

** *» 3 U. S. Code Congressional and Administrative

News, 1954, p. 4745. In support of its statement that there

was some confusion as to the current status of the law, the

Senate report compared Commissioner v. Caulkins to LT.

3486, 1941-2 Cum.Bul., p. 76. However, the Internal Rev-

enue holding, upon which the Senate Committee relied, dealt

only with a specific statutory provision which provided that

such gains realized on the sale of Treasury bills should be

interest. That provision had been enacted to make such

gains non-taxable by bringing them within the exemption

which interest enjoyed. Thus, the Senate Report does not

cite any evidence of uncertainty insofar as the generally

applicable principies are concerned.

At various times the Congress has enacted special provi-

sions regardi: 2 the treatment of discount. For instance,

the Internal Revenue Code of 1939, Sections 201(e) and

207(e), provided that stock and mutual life insurance com-

panies must accrue discount.

And in 1938 the House Ways and Means Committee dis-

cussed the relationship between discount and interest. That

Committee report stated:

‘‘It is important alsv to emphasize that there is no clear

separation, in practice, between capital gains and ordi-

nary income; * * * dA bond purchased at a premium re-

sults in a capital loss when redeemed at par, aid a bond

purchased at a discount, in a capital gain.’” Hearings on

H.R. 9682, Subeommittee of Committee on Ways and

Means, 75th Congress, Third Session, p. 38. (mphasis

added.)

Appendix C—Conflicting Opinions

Here again is evidence of Congressional knowledge that

appreciation due to bond discount was a capital gain. The

Subcommittee recommended that no change be made in this

rule.

And again, in Section 42(b) of the 1939 Internal Rev-

enue Code, the Congress gave taxpayers an election to treat

as current income the periodic increases in redemption

value of non-interest-bearing obligations issued at a dis-

count when such obligations were redeemable for fixed

amounts which increased at stated intervals.

Thus ti:e evidence indicates that the Congress clearly

believed that appreciation resulting from original issue dis-

count was a capital gain. With this knowledge Congress

adopted various pieces of specific legislation providing for

special treatment of discount in certain specified situations.

However, Congress took no action to change the general

law. These facts indicate a Congressional intention, until

1954, that capital gains treatment continue to be accorded

to gains resulting from bond discount. And there was no

indication of any thought that different treatment should be

given to gains resulting from original issue discount than

was accorded those resulting from other types of discount.

Both parties have cited various explanations and public

policies underlying the special treatment which the Cong-

ress has accorded to capital gains. As the Government has

indicated, there are several reasons for this special treat-

ment. However, even the Government cannot deny that one

important reason is to avoid taxing, at unusually high

rates, income which has in fact been earned over a number

of years but which is realized only in the year of sale. In

other words, the accumulation of: income actually accrued

over 2 period of years, but realized only in the year of sale,

which is inherent in the profitable sale of most capital! -as-

Appendix C—Conflicting Opinions

sets, would, under our system of highly progressive income

taxation, result in a taxation of such income at far higher

rates than would have been the case if the income had been

reportable in each of the years in which it acerued but was

not realized. The capital gains provisions place a limit

upon the extent to which such gains can be taxed. In view

of this purpose, it certainly appears that the long-term ap-

preciation, resulting from original issue discount of bonds

and other evidences of indebtedness, can be appropriately

fitted within that category of appreciation which is ac-

corded the special capital gains treatment.

In severa! instances the Tax Court has had occasion to

consider the proper method of taxing gains resulting from

original issue discount. It must be remembered that in

the Corn Exchange Bank case, supra, the Board of Tax

\ppeals held that discount was not interest. The next

occasion on which the Court was faced with the problem

was in Caulkins v. Commissioner, 1 T.U. 656 (1943). where

it decided that original issue discount gave rise to a capital

vain and not to regular income. It was this opinion which

was affirmed by the Sixth Circuit in Commissioner v. Caulk-

ins, supra.

In 1954, on a complex factual situation, it held that dis-

count was really interest and therefore gave rise to regular

income wen the securities were sold before maturity.

Paine v. Commissioner, 23 T.C. 391 (1954). That holding

was reversed by the Eighth Circuit in Paine v. Commis-

sioner, 236 F.2d 398 (1956). While it e: mot be said that

the Eighth Circuit held that discount resulted in a capital

gain, that Court did hold that the appreciation involved

in the Paine case was not interest. The language of the

Court further indicates, however, that it did not think that

Appendix C—Conflicting Opinions

discount created gains which were taxable as regular in-

come.

Another case before the Court was Commissioner v.

Morgan, 30 T.C. 881 (1958), involving accumulative invest-

meni certificates identical to those in the Caulkins case.

The Tax Court held that the appreciation on these certifi-

cates was a capital gain. The Commissioner appealed that

determination to the Ninth Circuit, which reversed the Tax

Court. Commissioner v. Morgan, 272 F.2d 936 (1959).

The Court of Appeals considered the Sixth Circuit’s Caulk-

ins decision and refused to follow it. The Court held that

Section 117(f) was designed only to allow capital gains

treatment to be accorded to ‘‘true’’ capital gains. The

Court refused to give the language of Section 117(f) the

all-encompassing scope that it had been accorded by the

Sixth Circuit.

The Tax Court reaffirmed its holding that such gains were

capital gains in Geodstein v. Commissioner, 30 T.C. 1178

(1958). And it was again faced with another of the Caulk-

ins-type accumulative investment certificates in Kormendy

v. Commissioner, 18 T.C.M. 353 (1959). This case was de-

cided after Morgan but before the reversal of Morgan by

the Ninth Cireuit. Again, the Tax Court affirmed its Mor-

gan and Caulkins holdings.

Finally, in 1960, after the reversal of the Morgan deci-

sion by the Court of Appeals, the Tax Court again had a

simiiar problem in Stanton v. Commissioner, 34 T.C. 1

(1960). In that case the taxpayer had purchased short-

term Government notes and commercial paper ai a discount.

This paper he sold before maturity but after holding for

more than six months. The excess of the amount re-:ized

over the cost was reported as a long-term capital gain. The

Tax Court held that the appreciation was regular income

Appendix C—Conflicting Opinions

because the notes were sold befcre maturity. In support

of this derasion the Court cited its Paine opinion, which it

said had been reversed on other grounds.

The most recent case that it has considered was Gib-

bons v. Commisioner, 37 T.C. No. 57. In Gibbons the

Tax Court held that discount was always interest, and

thus regvlar income, no matter whether it was realized

upon a sale or exchange before retirement, or upon the

retirement of a debt obligation. Thus, in Gibbons, the Tax

Court completely ejected the Caulkins decision, and

abandoned the distinction that it had made in Paine and

Stanton between gains realized on a sale and gains realized

on a retirement.

The problem of original issue discount has been con-

sidered recently by a number of constitutional courts. Most

of the decisions which were cited to this Court have but

again reaffirmed the validity of the general principle for

which the Government contends. When the evidences of

indebtedness in q::estion were interest-bearing obligations

the applicability of this proposition cannot be questioned.

Cases which have dealt with the rule in such situations are:

Fisher v. Commissioner, 209 F.2¢ 513 (6th C.r., 1954), cert.

den. 347 U.S. 1014, 74 S.Ci. 868, 98 L.Ed. 1136; United

States v. Langston, 308 F.2d 729 (5th Cir., 1962); Arnfeld

v. United States. 163 F.Supp. 865, 143 Ct.Cl. 277 (1958),

2ert. den. 359 U.S. 943, 79 S.Ct. 722, 3 L.Ed.2d 676; and

Jaglom v. Commissioner, 303 F.2d 847 (2d Cir., 1962) ;

ef. Commissioner v. Philhps, 275 F.2d 33 (4th Cir., 1960).

Thus, there are only five cases which actually have dealt

with the treatment to be accorded to gains resulting from

original issue discount. Those cases are: Commissioner

v. Caulkins, 14. F.2d 482 (6th Cir., 1944); Commissioner

v. Morgan, 272 F.2d 936 (9th Cir., 1959); Rosen v. United

Appendix C—Conflicting Opimions

States, 288 F.2d 658 (3d Cir., 1961); United States v.

Harrison, 304 F.2d 835 (Sth Cir., 1962); and Pattiz v.

United States, Ct.Cl., 311 F.2d 947 (1963). The Morgan

and Rosen decisions were based upon the same fact situa-

tical that was presented to the Sixth Circuit in Caulkins.

The results in the Third and Ninth Cireuits were obtained

by a specific rejection of the Caulkins decision. In neither

ease did the Court examine the legislative, administrative

or judicial history wiiich has surrounded the treatment of

original issue discount. Instead, the Court was presented

with the proposition on an almost de novo basis and, per-

haps naturally enough in the absence of femiliarity with the

detailed history, fel! back upon the broad, general proposi-

tion for which the Government here contends. Likewise,

the Harrison and Pattiz decisions were based upon a spe-

cific reject’ of Caulkins and on an adoption of the Morgan

and Rosen opinions, and neither case considered the histori-

cal treatment of original issue discount. Therefore, while

it is true tbat the recent cases have adopted the Govern-

ment’s position, they have done so (1) without a discussion

of the h’storica] treatment of gains resulting from original

issue discount, and (2) only upon a rejection of the Caulkin-

case, which is controlling in this Cireuit.

The following factors support the taxpayer's contentior :

(1) the cninions of the Department of Internal Revenue and

the Kuzrd of Tax Appeals, during the 1920°s and early

1930’s that discount was not interest; (2) Congressional!

belief, expressed both in 1929 upon authorization of Treas-

ury bills and later in the Second Liberty Bond -\ct, that

original issue discount resulted in a capital gain, and con-

sequent Congressional action to avoid that result; (3) the

report of the Subcommittee of the Ways and Means Com-

mittee of the House of Representatives, in 192s, that di--

Appendix C—Conflicting Opinions

count gave rise to a capital gain; (4) Congressional enact-

ment of various specific pieces of levislation providing that

appreciation resulting from discount would be ireated as

other than a capital gain; (5) the failure of the Congress

to take any action to change the treatment of bond discount

except in regard to highly specialized factual situations ,

(6} the passage of Section 117(f), as interpreted by the

Caulkins decisions, indicating that all amounts received

upon retirement, and attributable to original issue discount,

were capital gains; (7) the numerous early opinions of the

Tax Court that original issue discount resulted in a cap-

ital gain; and (8) the fact that none of the cases wh'ch have

rejected Caulkins have considered the historical treatmeut

of bond discount. Against these factors, and in support of

the Government’s contention, it is possible to infer, from

several administrative rulings dealing with specific statu-

tory situations, that bond discount was really interest and

was taxable as regular income. The 1929 Senate debate

and the 1938 House hearings refute any possible implica-

tion from other Congressional enactments that original

issue discount resulted in regular income. The factors

supporting the taxpayer’s contention are clearly of control-

ling weight.

It may well be that, in financial circles at least, original

issue discount is considered to be a form of interest. If

this is the ease, it is certainly understandable why the vari-

ous courts of appeal, which have considered this question

on an almost de novo basis, have held that original issue

discount resulted in reguiar income to the taxpayer. It is

likewise tri.e that there has 1 -en a .rend—commencing with

certain legislative enactments, proceeding through some

administrative interpretations, and culminating with the

(‘ongressionul enactment of 1954—ioward classifying ap-

Appenvix C—Conflicting Opinions

preciation resulting from original issue discount as interest.

This trend began with certain very specific factual situa-

tions and expanded to include nearly all governmental and

corporate evidences of indebtedness. However, careful

study of this developing trend confirms the Covurt’s belief

that it has effectuated a chrage in the law. The facts in

this case are not within any of the specific factual situations

for which this change has been macc and, therefore, the

Court is constrained to hold that, as to the notes here in

question, the appreciation for taxation purposes was not

interest but, rather, an appreciation on capital, and was

therefore taxable as a capital gain.

Shorli it be required, this memorandum will be adopted

as findings of fact and conclusions of law under Section

52(a), Federal Rules of Civil Procedure.

[335 F. (2d) 299 (2d Cir., 1964).]

Joseph I. Lusre and Evelyn J. Lubin, and Estate ot Joseph

Eisner, Deceased, Helen Eisner, Executrix, and Helen

Eisner, Petitioners,

( oMMISSIONER oF INTERNAL Revenue, Respondent.

Nos. 445, 446, Dockets 28804, 25805.

United States Court of Appeals

Second Circuit.

Argued May 7, 1964.

Decided July 27, 1964.

Before Waterman and Frienpuy, Circuit Judges, and

Anverson, District Judge.

Appendix C—Conflicting Opinions

WatTerMAN, Circuit Judge:

We are called upon in this case to determine whether a

sum of $1,000,000 realized by four taxpayers upon the re-

tirement of twelve registered mortgage notes, a sum rep-

resenting the difference between the $3,000,000 face value

of the rotes and the $2,000,000 which the taxpayers actually

paid for them upon issuance, is to be treated for income

tax purruses as ordinary income or as a capital gain. The

Tax Court, T. C. Memo 1963-292, concluded that the

$1,009,000 increment represents interest realized by the

taxpayers upon a principal sum, and therefore has ruled

that ordinary income treatment is proper and that the Com-

missioner’s assertion of deficiencies totaling $789,161.21

should be upheld. As we are of the opinion that the tax-

payers should have been accorded capitai gains treatment

on the increment here involved, we reverse the Tax Court.

The petitioner-taxpayers are two couples, Joseph Lubin

and wife and Samuel Eisner and wife, each of whom filed

joint income tax returns fer the calendar year 1954.’ At

the time the transactions relevant to this appeal arose,

Messrs. Lubin and Eisner were the senior partners in a

New York accounting firm. In March of 1953 Lubin was

approsched by a broker who advised him that the stock

of Sattlers, Inc., the largest denartment store in Buffalo,

New York, and the stock of Brighton Produets, Inc., the

corporation which operated the store’s meat department,

were being offered for sale for a total price of 46,500,000.

Lubin analyzed assorted financial data concerning the two

corporations in question, and as a result he happily con-

1. Eisner died on May 4, 1958, and his estate was made a party

to these proceedings. His wife, as executrix, is therefore a

party not only as a taxpayer, herself, against whom a deficiency

has been asserted, tut also as her deceased husband’s executrix.

Appendix C—Conflicting Opinions

cluded that net only did the corporations have a net worth

of more than $8,100,000 exciusive of good will, but also

that they had been generating an annual earned income

after taxes of about $700,000. This spelled out an easy and

almost certain profit of more than $2,000,000 for the for-

tunate person or persons who would purchase the stock

at the price then being asked. Lubin therefore informed

the broker that he and the other taxpayers were desirous

of going ahead with the purchase, they intending at that

time to buy the stock, operate the department store corpo-

rations for about a year, and then sell the stock at a profit

that wouid net them a long term capital gain.

The broker then revealed to Lubin that he was aciing on

behalf of a Buffalo businessman named Irving Levick who

had discovered the attractive opportunity, and who, ac-

cording to the broker, would have to be included among

those taking advantage of it. A meeting was arranged be-

tween Lubin and Levick, at which Levick disclosed that,

although he could arrange institutional financing in the

amount of $4,500,000 on the strength of the assets of the

two corporations to be purchased, he, Levick, did not have

the additional $2,000,000 necessary to close the deal. Lubin

then proposed that he and his fellow taxpayers participate

in the venture and furnish the needed cash in return for

a half share in the anticipated $2,000,000 profit; Levick

agreed. A discussion followed as to the form the proposed

transaction was to take, and Lubin made it clear to Levick

that, as the Lubins and Eisners were all in very high in-

come tax brackets, the gain to be realized by them on the

deal would have to be taxable at capital gains rates. Levick

rejected, however, Lubin’s suggestion that he and his as-

sociates buy all of the stock and sell it te Levick at the end

of the eapital gains period, Levick giving as his reason

Appendix C—Conflicting Opinions

his desire to own all of the stock and held himself out as.

proprietor of the companies involved from the very begin-

ing of the venture. Lubin asserted that the petitioners

were willing to cede such control to Levick at the outset as

long as a capital gains tax rate could be assured for them,

and, after the two negotiators agreed to formulate a plan

whereby petitioners could realize a profit of $1,000,000 tax-

able at the desired rate, Lubin set out to investigate what

sort of plan might serve this purpose. :

Toward this end Lubin sought the advice of the partner

in his accounting firm who was in charge of the firm’s tax

department, and he, relying on the decision in Commis-

sioner v. Caulkins, 144 F.2d 482 (6 Cir. 1944), and the Com-

missioner’s reported acquiescence in it, advised Lubin that

the desired profit and capital gains treatment could be as-

sured through the use of registered notes bearing a face

value of $1,000,000 greater than the anivunt the taxpayers

were to advance. Relying upon this advice, and upon his

own reaaing of the authorities cited to him by his partner,

Luvin decided to go ahead with the venture on this basis.

Accordingly, Lubin and Levick quickly set into operation

a series of arrangements designed to carry out the plan.

A corporation owned by Levick and his associates named

Seneca Warehouse & Industrial Center, Inc. (hereinafter

Seneca), organized a wholly owned subsidiary, Associated

Investors, ine., for the purpose of acquiring the stock of

the sought-for department store corporations. The peti-

tioners then advanced $2,000,000 to Seneca, Seneca made

this amcut available to Associated Investors, Inec., and

Associated Investors, Ine. combined this money with

$4,500,000 it had raised through institutional financing and

purchased the stock of the Buffalo department store corpo-

rations. In consideration for their advance of the $2,-

Appendia C--Conrflicting Opinions

00C 000 Lubin and the other petitioners received from

Seneca twelve registered mortgage notes having face

amounts of $250,000 each, totaling im full $3,000,000 and

dated June 29, 1953.2. The face amount of each note was

payable as follows: $187,500 on January 4, 1954, or a

little more than six months after issuance, and $9,208.53

on the fourth day of each month thereafter until January

4, 1955. The notes by «heir terms also provided for pay-

ment of interest at the rate of two per cent per annum on

face value. Sometime after January 4, 1954 all of the notes

were paid off in full, together with an additional sum of

$4,458.25 that was paid on each note representing the

agreed-upon two per cent interest charge, and the petition-

ers all reported as ordinary income on their 1954 federal

returns the amounts so received by them as st a interest.

The peti‘x aers all reported 1s long term capital gains,

however, the amounts recerved in payment of the face

value of each note which exceeded the sum the petitioners

originally advanced to the obligor, an excess which, com-

bined for all of them, was exactly $1,000,000. The Com-

missioner, alleging that these increments were taxable as

ordinary income as to each of the taxpayers, asserted de-

ficiencies against them for the calendar year 1954. The

Tax Court sustained the Commissioner. That Court ruled

that the $1,000,000 realized by the petitioning taxpayers

through the above described transaction was but interest

paid the taxpayers by Seneca for the use of the $2,000,000

which had been utilized in purchasing the stock of the two

department stores. On this appeal, the taxpayers argue

that the Tax Court erred in characterizing the amount in

2 Four notes were issued to Lubin and four were issued to his

wife: two notes were issued to Eisner, and two were issued to his

wife.

Appendix C-—Conflicting Opinions

controversy as interest, and that capital gains treatment

is therefore called for under Section 1232(a) (1) of the

1954 Code; as an alternative argument taxpayers claim

that the Commissioner is foreclosed from asserting the

alleged deficiencies against them because of his acquiescence

in Commissioner v. Caulkins, supra, which was of record

at the time the taxpayers entered into (ae transactions

which gave rise to the controversy. We need not discuss

taxpayers’ latter argument ‘though we do note that this

court’s recent decision in Dixon v. United States, 333 F.2d

1016 (2 Cir. 1964), relying on Automobile Club of Michigan

v. Commissioner, 353 U.S. 180, 183, 77 S.Ct. 707, 709, 1

L.Ed.2d 746 (1957), is very strong authority for rejecting

it) for we agree with taxpayers that, apart from any re-

liance they may have placed upon the Caulkins decision,

they are entitled to capital gains treatment under Section

1232(a) (1) of the 1954 Code.

i1}] Section 1232(a) (1), which controls as to the gain

here involved, provides that, in the case of bonds or other

evidences of indebtedness which are capital assets in the

hands of a taxpayer, ‘‘[a]mounts received by the holder on

retirement of such bonds or other evidences of indebtedness

skoll be considered as amounts received in ey hange ther>-

for (except that in the case of bonds or other evidences of

indebtedness issued before January 1, 1955, th's paragraph

shall apply only to ‘hose issued with interest coupons or

in registered form, or to those in such form on Mareh 1,

1°54).’’* Language identical in all material respects with

3. Section 1232(a) (2) of the 1954 Code now clearly provides that

a gain such as the one realized by these taxpavers is to be taxed

as ordinary income. Section 1232(a) (2) applies, howe ., only

to bonds or other evidences of indebtedness issued ai.-r Decem-

ber 31, 1954, and the notes we are concerned witi here were

issued one and one-half vears before that date, on June 29, 1953.

Appendix C—Conflicting Opinions

that used in Section 1232(a) (1) was considered in the

1944 case of Conimissioner v. Caulkins, supra, and the

court in that case interpreted Section 117(f) of the 1939

Code, the fore*unner of Section 1232(a) (1), so as to re-

quire capit2! gains treatment as a matter of law for all

amounts received upon the redemption of a bond. The

Caulkins decision stood as authority for a number of years,

but recent consideration of the problem presented in that

case, primarily in the light of an examiration of the legis-

lative history of Section 117(f) of the 19389 Code, has led

‘9 its express rejection by four Courts of Appeals, includ-

ing our own. Dixon v. United St-tes, supra ; United States

vy. Harrison, 304 i°.2d 835 (5 Cir. 1962), cert. denied, 372

U.S. 934, 83 S.Ct. 881, 9 L.Ed.2d 765 (1963) ; Rosen v.

United States, 288 F.2d 658 (3 Cir. 1961) ; Commissioner

y. Morgan, 272 F.2d 936 (9 Cir. 1959). See also Jaglom

vy. Commissioner, 303 F.2d 847 (2 Cir. 1962), where this

Court held that the portion cf the sales price of bonds which

represented unpaid interest that had accrued on them prior

to sale was to be taxed as ordinary income. We regard

these cases as clear authority for the proposition that

Caulkins was erroneously decided and ought now to be re-

garded as dead and buried, but we cannot agree with the

Commissioner, who relies upon them, ‘uat these cases re-

quire us to rule with the Tax Court that the amount in con-

troversy here must be taxed as ordinary income. As we

read the Dixon, Mason, Rosen, and Harrison decisions, they

lay down the very sound rule that, despite a contrary in-

ference which might be drawn from too literal a reading of

the language of Section 1282(a) (1), taxation at ordinary

income rates is proper where a sum paid upon the retire-

ment of a bond or note in fact represents interest for the

use of the money represented by the principal of che cer-

Appendix C—Conflicting Opinions

tificates of indebtedness. Unlike the situations which ob-

tained in the cited cases where the increments representing

an excess of face value over original cost were relatively

small, increased regularly year by year, and were clearly

interest equivalents,‘ in the situation before us the extra

amounts received upon retirement of the registered notes

did not represent interest but renresented the note holders’

share in profits realized through the purchase of under-

valned stock.

[2, 31 In determining how to characterize the gain in

this case, the statement from Deputy v. Du Pont, 308 U.S.

488, 498, 69 S.Ct. 363, 368, 84 L.Ed. 416 (1940), that ‘‘inter-

est on indebtedness means compensation for the use or

forbearance cf money,’’ while useful as a starting point, is

not dispositive of the issue before us, nor can it be. The

Commission:r would have us rule that anything avove face

value paid on notes by an obligor must, as a matter of law,

be regarded as interest, no matter what the substance

might be of the underlying transaction which has given rise

to the obligations. Of course this approach runs directly

counter to the admonitien laid down in Old Colony R. R.

Co. v. Commissioner, 284 U.S. 552, 561, 52 S.Ct. 211, 214,

76 L.Ed. 484 (1932), and later adopted in Deputy v. Du

Pont, supra, itself, 308 U.S. at 498, 60 S.Ct. at 368, that

4. Under the terms of the notes in the case at bar, three-quarters

of the face vurue was payable in just over six moni: s and the re-

maining onme-quarter was payable in equal monthly payments

over the course of the next twelve months. Since the face value

of the notes exceeded their eost by 50%, if the excess of face

value over original cost were to be considered as interest, the

‘‘interest’’ charge would figure out to be well in excess of 75%

per year and this rate would be charged for money used to con-

summate a deal where ail parties agreed that there was almost

no risk at all involved.

go eth AL AAS SERA CARE ST 0 Te EER ES PR Fp

Appendix C—Conflicting Opinions

the term ‘‘interest’’ when used by Congress is to be con-

strued according to ‘‘tne usual, ordinary, and everyday

meaning of the term’’ and not according to ‘‘some esoteric

concept derived from subtle and theoretic analysis.’’ As

this Court stated in Dixon v. United States, supra, 333 at

1016, after having completed an analysis purposed toward

reducing the transactions underlying the obligations there

involved ‘‘to their essentials’’: ‘‘It would seem arbitrary

to insist, as do the taxpayers, that sirmificant tax conse-

quences should hinge upon whether this * * * sum is sep-

arately stated as interest or is included in the face amount

of the note. It has been repeatedly emphasized that our

taxing statutes are intended to take cognizance of realities

and not mere appearances cr facades.’’ In the present

case it would seem that the Commissioner arbitrarily has

refused to take cognizance of the realities of the transac-

tion, and we think it reasonavle that what was said in

Dixon should apply to the Commissioner with the same

foree as to taxpayers.

[4] Of course, when reduced to their essentials, the

transactions which gave rise te the issuance of these nctes

did not comprehend that the increment of $1,000,000 was in-

terest for the use by the obligor of petitioners’ money. It

is undeniable that the petitioners’ business venture was

predicated from the very start upon their right to share,

on an equal basis with the Buffalo businessman Levick, a

proposed $2,000,000 protit to be derived from the purchase

of stock which was being undervalued by the seller. Their

original plan, once they learned of the need for Levick’s

participation, was to acquire the stock with a contract to

sel! it to Levick or the corporation at a profit of $1,CU0,000

after the passage of sufficient time to assure them of capital

gains treatment. The substance of the transaction is not

Appendix C—Conflicting Opinions

changed simply because they cast the deal in the form of

registered notes in order to accommodate Levick who de-

sired to te know: trum the time of original purchase as the

owner. As the Code does not require a profit realized in

this form to be treated as interest, and as the evidence re-

lating to the substance of the transaction afforded n_ basis

upon which the Tax Court could have concluded that these

profits were interest payments, we hold that § 1232(a) (1)

should be applied in accordance with its terms so that peti-

tioners will be taxed at capital gains rates.

Reversed.

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