Commissioner of Internal Revenue v. Korell

• Decision Date: 08 June 1949
• Docket Number: Docket 21225.,No. 202,202
• Citation: 176 F.2d 152
• Parties: COMMISSIONER OF INTERNAL REVENUE v. KORELL.
• Court: U.S. Court of Appeals — Second Circuit

176 F.2d 152 (1949)

COMMISSIONER OF INTERNAL REVENUE v. KORELL.

No. 202, Docket 21225.

United States Court of Appeals Second Circuit.

Argued May 11, 1949.

Decided June 8, 1949.

Rehearing Denied July 14, 1949.

Fred E. Youngman Sp. Asst. to the Atty. Gen., of Washington, D. C. (Theron Lamar Caudle, Asst. Atty. Gen., and Ellis N. Slack, Robert N. Anderson, and Sumner M. Redstone, Sp. Assts. to the Atty. Gen., all of Washington, D. C., on the brief), for petitioner.

Paul L. Peyton, of New York City (John J. Fogarty and Frederick H. Bruenner, both of New York City, on the brief), for respondent.

Before CHASE, CLARK, and DOBIE, Circuit Judges.

CLARK, Circuit Judge.

This case presents a problem as to the nature of the "amortizable bond premium" which was first allowed as a deduction from gross income for federal income tax purposes in 1942. The taxpayer has claimed such a deduction on his 1944 tax for the excess cost to him, over the amounts payable, of certain bonds which were callable at the debtor's option and convertible at his option into shares of the debtor's stock. His contention has been sustained by the Tax Court as against the Commissioner's contention that the statutory deduction is allowable only for a "true bond premium" and that the excess of cost in the case of convertible bonds of the kind here in issue is not of that nature.

Judge Opper for the Tax Court has written a carefully reasoned opinion, 10 T.C. 1001, which was reviewed by the whole court and which we think fully meets the issues presented by the Commissioner. In it he states the facts, which were stipulated, the rather lengthy statutory provision and treasury regulations, and certain of the committee reports explaining the statutory provision when it was adopted. Since the material is thus available, we shall merely refer to it where apposite without full quotation.

In August, 1944, respondent purchased $50,000 principal amount of American Telephone and Telegraph Company 15-year 3 per cent convertible debenture bonds, due September 1, 1956, at prices ranging from $121 to $121-1/4 per $100 principal and a total cost of $60,638.75. At that time the bonds were subject to call by the company on thirty days' notice at 104%; and, indeed, they were so called and paid on September 1, 1947. In his 1944 return, respondent claimed as a deduction the amount of $8,638.75, representing the difference between the cost, stated above, and the call price of $52,000. It is this deduction which the Commissioner disallowed in making his deficiency assessment and which is restored by the decision of the Tax Court, now before us on the Commissioner's petition for review.

To round out the picture, certain additional facts must be adverted to; indeed, these become crucial to the discussion. Under the terms of the bond respondent had the option, during all times here important, of converting the bonds into stock of the company by surrendering $100 principal of the bond issue and $40 in cash in exchange for each share of stock received. On the dates when he purchased the bonds the average selling price of the stock was $163.1875 and $163.6875 per share. The Commissioner, in arguing that the excess paid for the bonds here over their face value represented the value of the conversion rights, stresses the correspondence in value between the price of each bond plus $40 and the current quotation for the stock into which it could be converted. He adds that "it would be naive to assume that the bonds here involved were purchased at such exorbitant prices purely for investment purposes." We shall avoid the charge of naiveté by expressing no dissent; whatever respondent may actually have done with these bonds after 1944, certainly it would be perfectly normal to expect a holder to sell them in due course after the proper interval to take advantage of the lower rates for capital gains.¹ And the obvious advantage, taxwise, of transactions of this form might make such convertible bonds all the rage of security markets. Nevertheless the difficulties of a judicial attempt to remodel legislation to deal with such a situation at once fairly and not overdestructively remain obvious.

Let us then turn to the statute which still remains the best indicator of the legislative intent. Ex parte Collett, 337 U.S. 55, 69 S.Ct. 944; Gemsco, Inc., v. Walling, 324 U.S. 244, 260, 65 S.Ct. 605, 89 L.Ed. 921. After having provided for the deduction of "amortizable bond premium," I.R.C. § 23(v), 26 U.S.C.A. § 23(v), it goes on to define the latter. I.R.C. § 125, as added by § 126 of the Revenue Act of 1942, c. 619, 56 Stat. 798, 26 U.S.C.A. § 125. In summary it provides that the "amount of bond premium" shall be determined with reference to the (in this case) cost and the "amount payable on maturity or on earlier call date," and "the amortizable bond premium" of the taxable year shall be "the amount of the bond premium attributable to such year." I.R.C. § 125(b)(1) and (2), 26 U.S.C.A. § 125(b)(1, 2). As Judge Opper has stated the objective, "the premium paid must be recovered tax-free out of the earnings of the bond very much as depreciation must be recovered out of the income of depreciable property if the true distinction between income and recovery of capital is to be preserved."² Finally subd. (d), "Definition of bond," provides: "As used in this section, the term `bond' means any bond, debenture, note, or certificate or other evidence of indebtedness, issued by any corporation and bearing interest," and then goes on to exclude bonds constituting stock in trade of the taxpayer or held primarily for sale to customers in the ordinary course of business.

Thus it will be seen that there is here provided a complete statutory scheme applying in general terms to all forms of bonds, including — as is shown by the reference to the "call date" — callable bonds. Hence there is no sound basis for excluding from the operation of the statute convertible bonds, even though the premium paid on them might well be due more to the privilege of conversion than to other features, such as the callability of the bonds at a premium. And this, it is made clear by the Committee Reports, was the view of the legislators, for they so state in language relied upon by the Tax Court, so directly to the point that we shall quote it, viz: "The fact that a bond is callable or convertible into stock does not of itself prevent the application of this section. In the case of a callable bond, the earliest call date will, for the purposes of this section, be considered as the maturity date. Hence, the total premium is required to be spread over the period from the date as of which the basis of the bond is established down to the earliest call date, rather than down to the maturity date. In the case of a convertible bond, if the option to convert the bond into stock rests with the owner of the bond, the bond is within the purview of this section." H. Rep. No. 2333, 77th Cong., 2d Sess., 80 (1942 — 2 Cum.Bull. 372, 433, 434); Sen. Rep. No. 1631, 77th Cong., 2d Sess., 94 (1942 — 2 Cum.Bull. 504, 576).

The intent therefore to include convertible bonds generally within the operation of the statute cannot be questioned, and the Commissioner is really forced to the rather extreme position of saying that only the particular type of convertible bond here in issue does not have the "true bond premium," which alone, according to his view, is to be amortized. For this he cites as significant the precise wording of an applicable Treasury Regulation. In fact, the section, after permitting "the method of amortizing bond premium regularly employed by the holder of the bond" to be used "if such method is reasonable," then provides that the method in all other cases shall be "in accordance with regulations prescribing reasonable methods of amortizing bond premium, prescribed by the Commissioner with the approval of the Secretary." I.R.C. § 125(b)(3) (A) and (B), 26 U.S.C.A. § 125(b)(3)(A, B). This appears to concern more the method of computing the yearly deductions than the allowance of the deductions themselves. At any rate, § 29.125 of Treas. Reg. 111 contains extensive and detailed provisions which, inter alia, accept complete application of the section to both callable and convertible bonds. The provision most in point here, subsec. 5 of § 29.125 of Treas.Reg. 111, first states: "The fact that a bond is callable or convertible into stock does not, in itself, prevent the application of section 125." It then goes on to provide that in...