Dixon v. United States

• Decision Date: 01 November 1963
• Citation: 224 F. Supp. 358
• Parties: W. Palmer DIXON et al., Plaintiffs, v. UNITED STATES of America, Defendant.
• Court: U.S. District Court — Southern District of New York

224 F. Supp. 358

W. Palmer DIXON et al., Plaintiffs, v. UNITED STATES of America, Defendant.

United States District Court S. D. New York.

November 1, 1963.

Stroock & Stroock & Lavan, New York City, for plaintiffs; Bernard E. Brandes, Sanford Saideman, New York City, of counsel.

Robert M. Morgenthau, U. S. Atty., S. D. New York, for defendant; Robert Arum, Morton L. Ginsberg, Asst. U. S. Attys., of counsel.

LEVET, District Judge.

These are cross motions for summary judgment in an action for refund of federal income taxes paid by the plaintiffs for the taxable year 1952 in the sum of $369,329.65 plus interest. Jurisdiction is based upon 28 U.S.C. § 1346(a). The parties agree, except for one fact, which will be dealt with later, that there are no issues as to any material facts.

The facts surrounding this claim for refund are as follows:

During the year 1952, the plaintiffs were partners in the investment firm of Carl M. Loeb Rhoades & Co. (hereinafter "partnership"), a member of the New York and American Stock Exchanges. The principal sources of income of the partnership are from commissions earned on sales of customers' securities, the underwriting and selling of securities and from trading and investing on its own account.

During 1952, the partnership acquired 33 short-term non-interest bearing notes, commonly known as commercial paper. All of the notes were issued at a discount which ranged from 2 3/8 to 3¾% on the face value of the notes. The notes were purchased either directly from the issuing obligor corporation or through agents or dealers on the original date of issue. The notes had maturity dates between 190 and 272 days from the date of issue. All of these notes were either sold subsequent to six months after their purchase or were retained, unmatured, at the close of the taxable year 1952.

Plaintiffs reported the distributive share of the profit realized from the sale by the partnership of 20 of the notes during the year 1952 as long-term capital gain. The Internal Revenue Service disallowed capital gain treatment and computed the discount earned per day for each note by dividing the number of days between issuance and maturity into the total discount. The earned discount per day, multiplied by the number of days the notes were held during 1952, either before sale or as of December 31, was considered as "discount earned." The Internal Revenue Service treated the amount of "discount earned" as ordinary income. Deficiencies were assessed against the plaintiffs. The deficiencies were paid, a claim for refund was duly filed, and this action was thereafter commenced.

The parties differ as to the treatment which should be accorded to the original issue discounts. The plaintiffs claim that the amounts so realized are long-term capital gains, while the Internal Revenue Service held them to be interest, therefore, ordinary income. In addition, the plaintiffs urge the Commissioner of Internal Revenue's prior acquiescence in 1944 in the case of Commissioner of Internal Revenue v. Caulkins, 144 F.2d 482 (6 Cir. 1944), affirming 1 T.C. 656 (1943), estops the Internal Revenue Service from now claiming that original issue discounts should be treated as interest since they relied on the Caulkins' acquiescence when they purchased the securities in 1952.

Thus, the issue is squarely before the court: Aside from any consideration of reliance or estoppel, when short-term non-interest bearing notes are purchased at a discount, is the amount of such discount when realized in the nature of interest or a capital gain?

DISCUSSION

A. STATUTES INVOLVED

There are two sections of the Internal Revenue Code of 1939 which must be considered in determining this action. They are Sections 22 and 117(a) (1). Section 22 provides:

"§ 22. Gross income

"(a) General definition `Gross income' includes gains, profits, and income derived from salaries, wages, or compensation for personal service (including personal service as an officer or employee of a State, or any political subdivision thereof, or any agency or instrumentality of any one or more of the foregoing), of whatever kind and in whatever form paid, or from professions, vocations, trades, businesses, commerce, or sales, or dealings in property, whether real or personal, growing out of the ownership or use of or interest in such property; also from interest, rent, dividends, securities, or the transaction of any business carried on for gain or profit, or gains or profits and income derived from any source whatever. * *"

Section 117(a) (1) provides:

"§ 117. Capital gains and losses

"(a) Definitions. As used in this chapter—

"(1) Capital assets. The term `capital assets' means property held by the taxpayer (whether or not connected with his trade or business), but does not include—

"(A) stock in trade of the taxpayer or other property of a kind which would properly be included in the inventory of the taxpayer if on hand at the close of the taxable year, or property held by the taxpayer primarily for sale to customers in the ordinary course of his trade or business;

"(B) property, used in his trade or business, of a character which is subject to the allowance for depreciation provided in section 23(l), or real property used in his trade or business;

"(C) * * *

"(D) an obligation of the United States or any of its possessions, or of a State or Territory, or any political subdivision thereof, or of the District of Columbia, issued on or after March 1, 1941, on a discount basis and payable without interset sic at a fixed maturity date not exceeding one year from the date of issue."

B. DOES THE 1939 CODE ALLOW ORIGINAL ISSUE DISCOUNTS TO BE TREATED AS CAPITAL GAINS?

The plaintiffs rely heavily upon the case of George Peck Caulkins, supra. The Caulkins case involved a taxpayer who paid $15,043.33 over a ten-year period for an accumulative installment certificate which returned him $20,000 at the end of the ten years when the certificate was redeemed. The Tax Court and the Circuit Court of Appeals for the Sixth Circuit held that the difference between the amount paid and the amount received by the taxpayer upon redemption was a long-term capital gain. This result was achieved primarily through a peculiar application of Section 117(f), which provided:

"(f) 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."

The two courts were of the opinion that $4,956.67 increment received by the taxpayer was a capital gain because Section 117(f) makes the amounts received by the holder on retirement of a certificate or other evidence of indebtedness capital gains. Therefore, on the basis of the Caulkins case, the plaintiffs urge that the increment as a result of an original issue discount on a note sold before maturity would result in a capital gain and not ordinary income.

C. THE CAULKINS CASE WAS WRONGLY DECIDED.

It is clear that the Courts in the Caulkins case wrongly interpreted the purpose and scope of Section 117(f). The situation which gave rise to the enactment of Section 117(f) is illustrated by the case of Fairbanks v. United States, 306 U.S. 436, 59 S.Ct. 607, 83 L.Ed. 855 (1939). There, the taxpayer acquired bonds at less than par value. The court held that the increment received upon the retirement of the bonds could not be considered as capital gains because the redemption of the bonds was not a "sale or exchange thereof" and the statute defined a capital gain as meaning "taxable gain from the sale or exchange of capital assets." Following the Fairbanks case Section 117(f) was enacted.

It seems plain that Section 117(f) was not designed to accomplish any other purpose but to reverse the type of result achieved in the Fairbanks case. Nowhere in the text of Section 117(f) or in its legislative history is there any indication that if, upon retirement of such bonds, the increment a taxpayer receives would be converted into capital assets or treated as capital gains.

The literal language of Section 117(f) if applied to facts identical to those in the Caulkins case, supra, yields only one conclusion, the increment should be treated as ordinary income. The operative words of Section 117(f) are: "Amounts received by the holder upon the retirement * * * shall be considered as amounts in exchange therefor." In a Caulkins-type fact situation, we have a combination of both a capital asset (the note or other evidence of indebtedness) and the interest on other earnings from that asset. The courts in Caulkins failed to realize that the gain realized from the deemed 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 increment by way of interest or discount together and considered the combined amount as a capital gain.

The rationale of the Caulkins case has been repudiated in recent years by other courts which had cases similar to Caulkins. See Commissioner of Internal Revenue v. Morgan, 272 F.2d 936 (9 Cir. 1959); Rosen v. United States, 288 F.2d 658 (3 Cir. 1961); United States v. Harrison, 304 F.2d 835 (5 Cir. 1962), cert. denied 372 U.S. 934, 83 S.Ct. 881, 9 L.Ed.2d 765 (1963); Pattiz v. Commissioner, 311 F.2d 947 (Ct.Cl.1963); Richard B. Gibbons, 37 T.C. 569 (1961); V. David Leavin, 37 T.C. 766 (1962).

THE PLAINTIFFS' CLAIM OF RELIANCE UPON THE CAULKINS ACQUIESCENCE.

The plaintiffs claim that they relied on the Caulkins case and the acquiescence in Caulkins by the Treasury Department when they entered into these transactions in 1952. Since Caulkins has been repudiated...