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

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## Record

- **Collection:** Supreme Court brief
- **Document type:** Petition for Writ of Certiorari
- **Published:** January 1, 1965
- **Citation:** 381 U.S. 911

## Text

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,
v.

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,
v.
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.

2

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

3

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.

4

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.

5

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.

6

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.

7

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.

8

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.

11
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.

12
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.

13
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

14
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... .

>

15
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.”’

16
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“ 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

41
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 -
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.

5d
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-

56
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

57
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

58
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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Source: Frix Law Library, https://www.frixlaw.com/law-library/documents/brief%3Amicro_IA40385602_0514%3A2. Public record. Not legal advice.