UNITED STATES v. MIDLAND-ROSS CORP.(1965)
Respondent taxpayer in 1952-1954 bought noninterest-bearing promissory notes at prices discounted below the face amounts and held them over six months. Before maturity and in the year of purchase it sold each below the face amount but for more than the issue price. The gains, concededly the economic equivalent of interest, were reported as capital gains. The Commissioner of Internal Revenue determined that the gains attributable to original issue discount were but interest in another form and therefore taxable as ordinary income. After paying the deficiencies respondent brought this refund action which both the District Court and the Court of Appeals decided in its favor. Held: Earned original issue discount is not entitled to capital gains treatment under the 1939 Internal Revenue Code. Pp. 56-67.
Frank I. Goodman argued the cause for the United States. With him on the brief were Solicitor General Cox, Assistant Attorney General Oberdorfer, Wayne G. Barnett and Joseph Kovner.
Theodore R. Colborn argued the cause for respondent. With him on the brief was Theodore M. Garver.
MR. JUSTICE BRENNAN delivered the opinion of the Court.
The question for decision is whether, under the Internal Revenue Code of 1939, certain gains realized by the taxpayer are taxable as capital gains or as ordinary income. The taxpayer bought noninterest-bearing promissory notes from the issuers at prices discounted below the face amounts. With one exception, each of the notes was held for more than six months, and, before maturity and in the year of purchase, was sold for less than its face amount but more than its issue price. 1 It is conceded that the [381 U.S. 54, 56] gain in each case was the economic equivalent of interest for the use of the money to the date of sale but the taxpayer reported the gains as capital gains. The Commissioner of Internal Revenue determined that the gains attributable to original issue discount were but interest in another form and therefore were taxable as ordinary income. Respondent paid the resulting deficiencies and in this suit for refund prevailed in the District Court for the Northern District of Ohio, 214 F. Supp. 631, and in the Court of Appeals for the Sixth Circuit, 335 F.2d 561. Because this treatment as capital gains conflicts with the result reached by other courts of appeals, 2 we granted certiorari. 379 U.S. 944 . We reverse.
The more favorable capital gains treatment applied only to gain on "the sale or exchange of a capital asset." 117 (a) (4). Although original issue discount becomes property when the obligation falls due or is liquidated prior to maturity and 117 (a) (1) defined a capital asset as "property held by the taxpayer," 3 we have held that
Earned original issue discount serves the same function as stated interest, concededly ordinary income and not a capital asset; it is simply "compensation for the use or forbearance of money." Deputy v. du Pont, 308 U.S. 488, 498 ; cf. Lubin v. Commissioner, 335 F.2d 209 (C. A. 2d Cir.). Unlike the typical case of capital appreciation, the earning of discount to maturity is predictable and measurable, and is "essentially a substitute for . . . payments which 22 (a) expressly characterizes as gross income [; thus] it must be regarded as ordinary income, and [381 U.S. 54, 58] it is immaterial that for some purposes the contract creating the right to such payments may be treated as `property' or `capital.'" Hort v. Commissioner, supra, at 31. The $6 earned on a one-year note for $106 issued for $100 is precisely like the $6 earned on a one-year loan of $100 at 6% stated interest. The application of general principles would indicate, therefore, that earned original issue discount, like stated interest, should be taxed under 22 (a) as ordinary income. 4
The taxpayer argues, however, that administrative practice and congressional treatment of original issue discount under the 1939 Code establish that such discount is to be accounted for as capital gain when realized. Section 1232 (a) (2) (A) of the Internal Revenue Code of 1954 5 provides that "upon sale or exchange of . . . evidences [381 U.S. 54, 59] of indebtedness issued after December 31, 1954, held by the taxpayer more than 6 months, any gain realized . . . [up to the prorated amount of original issue discount] shall be considered as gain from the sale or exchange of property which is not a capital asset," that is, it is to be taxed at ordinary income rates. From this the taxpayer would infer that Congress understood prior administrative and legislative history as extending capital gains treatment to realized original issue discount. If administrative practice and legislative history before 1954 did in fact ignore economic reality and treat stated interest and original issue discount differently for tax purposes. the taxpayer should prevail. See Hanover Bank v. Commissioner, 369 U.S. 672 ; Deputy v. du Pont, supra; cf. Helvering v. R. J. Reynolds Tobacco Co., 306 U.S. 110 . But the taxpayer must persuade us that this was clearly the case, see Watson v. Commissioner, supra, at 551, and has not done so.
The taxpayer refers us to various statutory provisions treating original issue discount as ordinary income in specific situations, arguing that these establish a congressional understanding that in situations not covered by such provisions, original issue discount is entitled to capital [381 U.S. 54, 60] gains treatment. Even if these provisions were merely limited applications of the principle of 1232 (a) (2), they may demonstrate, not that the general rule was to the contrary, but that the general rule was unclear, see Brandis, Effect of Discount or Premium on Bondholder's North Carolina Income Tax, 19 N.C. L. Rev. 1, 7 (1940), and that Congress wished to avoid any doubt as to its treatment of particular situations. Cf. S. Rep. No. 1622, 83d Cong., 2d Sess., p. 112 (1954).
First we are referred to 42 (b) and 42 (c) of the 1939 Code. 6 Section 42 (b) applied, inter alia, to discounted noninterest-bearing obligations periodically redeemable for specified increasing amounts, and permitted [381 U.S. 54, 61] cash-basis taxpayers an election to accrue the annual increase. If anything, the statutory language supports the Government's position, for it implies that an accrual-basis taxpayer has no election, but must accrue the increases; this seems to indicate a congressional understanding that such increases were ordinary income. Section 42 (c) postpones recognition of discount on short-term government obligations until maturity or sale. That provision, however, has its own history. Earlier law, requiring the proration of original issue discount according to the time the obligation was held, was considered to "impose on taxpayers the duty of making burdensome computations." See S. Rep. No. 673, Part 1, 77th Cong., 1st Sess., p. 30 (1941). The proration provisions had in turn succeeded a statute enacted, not to make an exception to a general rule of capital gains treatment for issue discount, but to insure that the then-existing exemption for discount as representing interest could be claimed by taxpayers other than the original holder. H. R. Conf. Rep. No. 17, 71st Cong., 1st Sess., p. 2 (1929). Since the tax exemption for Treasury paper was eliminated in 1941, there was no longer any important reason to distinguish exempt original issue discount from nonexempt market discount, and 42 (c) was enacted expressly to simplify administration by eliminating the necessity for allocation between interest and capital gain or loss, and treating all discount as income, but taxable only on realization. 7 If [381 U.S. 54, 62] the inferences drawn by respondent were correct, these provisions would be rendered superfluous by the enactment of 1232 (a) (2), but they have been carried forward as 454 (a) and (b) of the 1954 Code.
It is also argued that 201 (e) and 207 (d) of the 1939 Code 8 manifested a congressional view opposed to ordinary income treatment. These sections required annual accrual of bond premium and discount by life and mutual casualty insurance companies. But again, somewhat like 42 (b), these provisions provided for accrual by cash-basis taxpayers. See Massachusetts Mutual Life Ins. Co. v. United States, 288 U.S. 269 . Moreover, the Commissioner [381 U.S. 54, 63] had interpreted these provisions as requiring him to treat market discounts or premiums, as well as interest agreed upon by the borrower in the guise of original issue discount, as ordinary income items. 9
Thus, the taxpayer has not demonstrated that, in specifying ordinary income treatment for original issue discount in particular situations. Congress evinced its understanding that such discount would otherwise be entitled to capital gains treatment. Therefore we turn to the question whether Treasury practice and decisional law preclude ordinary income treatment.
The taxpayer premises this part of his argument primarily upon the case of Caulkins v. Commissioner, 1 T. C. 656, acq., 1944 Cum. Bull. 5. aff'd, 144 F.2d 482 (C. A. 6th Cir.), acq. withdrawn, 1955-1 Cum. Bull. 7. 10 The taxpayer there purchased an "Accumulative Installment Certificate" providing for 10 annual payments of $1,500 in return for $20,000 at the end of 10 years. The certificate provided for gradually increasing cash surrender and loan values. In 1939 the taxpayer received $20,000 as agreed and, relying on the long-term capital gains provisions of the Revenue Act of 1938, c. 289, 52 Stat. 447, reported only half the profit as taxable income. Acting primarily on the theory that the certificate was not in registered form as required by 117 (f), the Commissioner sought to treat the increment as interest or as income arising out of a transaction entered into for profit. The Tax Court upheld the taxpayer, finding that the certificate was in [381 U.S. 54, 64] registered form within the meaning of 117 (f) of the Revenue Act of 1938, a provision identical to 117 (f) of the 1939 Code, 11 but its discussion of the capital gains question is at best opaque. 12 The Court of Appeals acknowledged that "the transaction presents no true aspect of capital gain" and that "Congress might well have made the differentiation urged by the Commissioner, since it is difficult to perceive any practical reason for taxing increment of the type involved here differently from ordinary income . . . [as] consideration paid for the use [381 U.S. 54, 65] of the amounts paid in. . . ." 144 F.2d, at 484. Nevertheless it construed the words "amounts received by the holder upon . . . retirement" in 117 (f) as unsusceptible of partition, and therefore as including the increment attributable to interest, which, with the principal amount, was thus taxable only as capital gain.
Caulkins did not unambiguously establish that original issue discount was itself a "capital asset" entitled to capital gains treatment. It held only that under 117 (f) Congress had not provided that the "amount" received on retirement might be broken down into its component parts. This was inconsistent with the view expressed in Williams v. McGowan, 152 F.2d 570 (C. A. 2d Cir.). and approved by this Court in Watson v. Commissioner, supra, at 552, that "Congress plainly did mean to comminute the elements of a business; plainly it did not regard the whole as `capital assets.'" 152 F.2d, at 572. The Tax Court has consistently regarded Caulkins as having erroneously read 117 (f) to preclude differentiation of the sources of proceeds on redemption. Paine v. Commissioner, 23 T. C. 391, 401, reversed on other grounds, 236 F.2d 398 (C. A. 8th Cir.); Stanton v. Commissioner, 34 T. C. 1; see 3B Mertens, The Law of Federal Income Taxation 184-186, 378-381 (Zimet rev.). The Commissioner, in addition to withdrawing his acquiescence in Caulkins, has also rejected the interpretation of "amount" under 117 (f) as not subject to apportionment under general principles. Rev. Rul. 119, 1953-2 Cum. Bull. 95; Rev. Rul. 55-136, 1955-1 Cum. Bull. 213; Rev. Rul. 56-299, 1956-1 Cum. Bull. 603. To the extent the Tax Court's decision in Caulkins rested, as its opinion indicates, on a reading of 117 (f) to require more favorable treatment on redemption than on sale, it is clearly at odds with the legislative purpose, which was merely to treat alike redemptions and sales or exchanges of securities in registered form or with coupons attached, [381 U.S. 54, 66] and not to extend the class of capital assets. Rev. Rul. 56-299, supra. Such an interpretation, which would not benefit the taxpayer in the sale transactions here involved, may underlie the Tax Court's decision but it has no justification in logic or in the legislative history, and even the taxpayer would reject such a meaning, however well supported by the Caulkins acquiescence. Finally, notwithstanding the acquiescence, what little other administrative practice we are referred to seems contrary to Caulkins. See I. T. 1684, II-1 Cum. Bull. 60 (1923).
The concept of discount or premium as altering the effective rate of interest is not to be rejected as an "esoteric concept derived from subtle and theoretic analysis." Old Colony R. Co. v. Commissioner, 284 U.S. 552, 561 . For, despite some expressions indicating a contrary view. 13 this Court has often recognized the economic function of discount as interest. In Old Mission Co. v. Helvering. 293 U.S. 289, 290 , for example, the Court regarded it as "no longer open to question that amortized bond discount may be deducted in the separate return of a single taxpayer." 14 The radical changes since Caulkins in the concept of treatment of accumulated interest under the 1939 Code are consistent with this. For example, accrued bond interest on stated interest bonds sold between interest dates has long been taxable to the seller of the bonds. See I. T. 3175, 1938-1 Cum. Bull. 200. But on "flat" sales of defaulted notes at prices in excess of face [381 U.S. 54, 67] amount, with no attribution of interest arrearages in the sale price, the requirement of allocation to treat a portion of the proceeds as ordinary income dates only from 1954. Fisher v. Commissioner, 209 F.2d 513 (C. A. 6th Cir.); see Jaglom v. Commissioner, 303 F.2d 847 (C. A. 2d Cir.). The propriety of such allocation in the present case is even more evident; unlike defaulted bond interest. there is no suggestion that full payment of the original issue discount will not be made at maturity.
For these reasons we hold that earned original issue discount is not entitled to capital gains treatment under the 1939 Code.
[ Footnote 2 ] Real Estate Investment Trust of America v. Commissioner, 334 F.2d 986 (C. A. 1st Cir.), petition for writ of certiorari pending, No. 620; Dixon v. United States, 333 F.2d 1016 (C. A. 2d Cir.), affirmed, post, p. 68; Rosen v. United States, 288 F.2d 658 (C. A. 3d Cir.); United States v. Harrison, 304 F.2d 835 (C. A. 5th Cir.); Commissioner v. Morgan, 272 F.2d 936 (C. A. 9th Cir.). See also Pattiz v. United States, 160 Ct. Cl. 121, 311 F.2d 947; Schwartz v. Commissioner, 40 T. C. 191; Leavin v. Commissioner, 37 T. C. 766; Gibbons v. Commissioner, 37 T. C. 569.
[ Footnote 3 ] "Sec. 117. Capital Gains and Losses.
[ Footnote 4 ] Our disposition makes it unnecessary to decide certain questions raised at argument, as to which we intimate no view:
(1) Since each note was sold in the year of purchase, we do not reach the question whether an accrual-basis taxpayer is required to report discount earned before the final disposition of an obligation:
(2) Since no argument is made that the gain on the sale of each note varied significantly from the portion of the original issue discount earned during the holding period, we do not reach the question of the tax treatment under the 1939 Code of "market discount" arising from post-issue purchases at prices varying from issue price plus a ratable portion of the original issue discount, or of the tax treatment of gains properly attributable to fluctuations in the interest rate and market price of obligations as distinguished from the anticipated increase resulting from mere passage of time.
[ Footnote 5 ] "Sale or exchange. -
We intimate no view on the construction of this statute. In particular, we imply no view upon the Commissioner's implicit contention that accrual-basis taxpayers are required to report discount as earned prior to final disposition of obligations acquired after December 31, 1954. Cf. Lubin v. Commissioner, supra.
[ Footnote 6 ] "Sec. 42. Period in Which Items of Gross Income Included.
[ Footnote 7 ] Since the statute applied only to paper with maturity of a year or less, the simplification resulting from recognizing income only on realization outweighed the possible shifting of income between tax years by accrual-basis taxpayers. At the same time, short-term government paper was excluded from the definition of "capital asset" in 117 (a) (1) (D) of the 1939 Code, avoiding the necessity of separating out the amount of proceeds attributable to market fluctuations rather than earned discount. This exclusion is carried forward as 1221 (5) of the 1954 Code.
[ Footnote 8 ] "Sec. 201. Life Insurance Companies.
[ Footnote 9 ] This provision was eliminated and the life insurance provision amended by the Revenue Act of 1964, 228, 78 Stat. 19, 98-99, amending 818 (b), 822 (d) (2) of the 1954 Code. See S. Rep. No. 830, 88th Cong., 2d Sess., pp. 122-124, for a detailed explanation.
[ Footnote 10 ] We consider the decisions and acquiescence only as evidence of the earlier understanding of the tax law. With respect to the claim of a particular taxpayer that he relied to his detriment on the acquiescence, see Dixon v. United States, post, p. 68.
[ Footnote 11 ] "Retirement of Bonds, Etc. - For the purposes of this chapter, amounts received by the holder upon the retirement of bonds, debentures, notes, or certificates or other evidences of indebtedness issued by any corporation (including those issued by a government or political subdivision thereof), with interest coupons or in registered form, shall be considered as amounts received in exchange therefor."
[ Footnote 12 ] The entire discussion of the capital gains question is as follows:
[ Footnote 13 ] See, e. g., New York Life Ins. Co. v. Edwards, 271 U.S. 109, 116 ; Old Colony R. Co. v. Commissioner, supra. Though these bond premium cases are said to be inconsistent with the view taken here, they are equally inconsistent with the treatment of discount to the borrower.
[ Footnote 14 ] See also Helvering v. Union Pacific R. Co., 293 U.S. 282, 285 , 288; Western Maryland R. Co. v. Commissioner, 33 F.2d 695, 696 (C. A. 4th Cir.); Longview Hilton Hotel Co. v. Commissioner, 9 T. C. 180, 182. [381 U.S. 54, 68]