Microdot, Inc. v. U.S.

• Decision Date: 24 February 1984
• Docket Number: No. 408,D,408
• Citation: 728 F.2d 593
• Court: U.S. Court of Appeals — Second Circuit
• Parties: 84-1 USTC P 9262 MICRODOT, INC., Plaintiff-Appellant, v. UNITED STATES of America, Defendant-Appellee. ocket 83-6214.

Page 593

728 F.2d 593

84-1 USTC P 9262

MICRODOT, INC., Plaintiff-Appellant, v. UNITED STATES of America, Defendant-Appellee.

No. 408, Docket 83-6214.

United States Court of Appeals, Second Circuit.

Argued Dec. 9, 1983.

Decided Feb. 24, 1984.

Michael F. Duhl, Chicago, Ill. (Glen H. Kanwit, Michael A. Clark, and Hopkins & Sutter, Chicago, Ill.; Robert H. Ware, and Mattern, Ware, Stoltz & Fressola, Bridgeport, Conn., on the brief), for plaintiff-appellant.

Farley P. Katz, Atty., Dept. of Justice, Washington, D.C. (Glenn L. Archer, Jr., Asst. Atty. Gen., Michael L. Paup and Ernest L. Brown, Attys., Dept. of Justice, Washington, D.C.; Alan H. Nevas, U.S. Atty., Bridgeport, Conn., on the brief), for defendant-appellee.

Before TIMBERS, VAN GRAAFEILAND and NEWMAN, Circuit Judges.

TIMBERS, Circuit Judge:

Appellant Microdot, Inc. (Microdot) appeals from a judgment entered May 27, 1983 in the District of Connecticut, T.F. Gilroy Daly, Chief Judge, upon the recommendation of Magistrate Thomas P. Smith, granting the government's motion for summary judgment and denying Microdot's motion for summary judgment in a tax refund action commenced by Microdot to recover federal corporate income taxes for the calendar year 1975 in amount of $44,612, plus interest, claimed to have been erroneously assessed and collected.

The district court held that Microdot's issuance of debentures in exchange for nearly 10% of its outstanding common stock was a reorganization within the meaning of I.R.C. Sec. 368(a)(1) ¹ and that, accordingly, under I.R.C. Sec. 1232(b)(2), Microdot incurred no original issue discount and could take no corresponding deduction. This appeal followed. We affirm.

I.

The facts, having been stipulated, are not in dispute.

Microdot is a Delaware corporation with its principal office in Darien, Connecticut. On April 7, 1975, Microdot issued, pursuant to an exchange offer to its shareholders, $6,064,400 principal amount of a new issue of 10% Subordinated Sinking Fund Debentures, due February 1, 2000, in exchange for 404,298 shares of Microdot common stock. Stock was exchanged at the rate of $15 principal amount of debentures per share of stock. Each debenture was redeemable at $100 at maturity.

On the day after this exchange, a portion of the issue of debentures was traded over the counter at a price of $75 per $100 principal amount of debenture. The aggregate fair market value of the issue of debentures on the first day they were traded was $4,548,300. Microdot claims that the difference between the face amount of the debentures and the fair market value--$1,516,100--represented an original issue discount within the meaning of I.R.C. Sec. 1232(b)(1), entitling it to an amortized deduction in amount of $75,528 for the calendar year 1975.

In accordance with Treasury Regulations, Microdot sent a Form 1099-OID to each of the debenture holders, advising them of their proportionate share of the original issue discount reportable as income on their individual tax returns. Microdot filed information returns accordingly with the Internal Revenue Service (IRS).

On September 25, 1979, the IRS assessed additional income tax in amount $146,246, plus interest in amount $33,717, against Microdot for the calendar year 1975. Part of this additional tax resulted from the IRS' disallowance of the deduction taken by Microdot in the amount of $75,528 for what it claimed to be the first year's amortization of original issue discount. On October 10, 1979, Microdot paid the assessed amounts. On June 3, 1980, it filed a timely claim for refund of income tax paid. The claim sought the additional tax paid as a result of the disallowance of the original issue discount deduction.

The IRS neither allowed nor disallowed the claim for refund within six months. Microdot consequently commenced the instant action in the district court on March 31, 1981.

After the pleadings were closed, the parties filed a stipulation of facts. The parties thereupon filed cross-motions for summary judgment which the court referred to a magistrate. On March 28, 1983, the magistrate recommended that Microdot's motion be denied and that the government's motion be granted. These recommendations were accepted by the court and judgment was entered as stated above.

Despite Microdot's able written and oral arguments in our Court, we hold, for the reasons set forth below, that the 1975 exchange of debentures for common stock was a recapitalization within the meaning of I.R.C. Sec. 368(a)(1)(E).

II.

The sole issue on this appeal is whether Microdot's issuance of debentures in exchange for shares of its common stock constituted a recapitalization within the meaning of I.R.C. Sec. 368(a)(1)(E). If we answer in the affirmative, as the government urges, then Sec. 1232(b)(2), as it provided in 1975, specifies that the issue price of the debentures is the stated maturity price of the debentures, rather than the fair market value of the property received in exchange therefor, resulting in no original issue discount.

Microdot, in urging us to hold that the exchange of debentures for common stock was not a recapitalization within the meaning of the statute, relies heavily on the fact that the transaction was a taxable event affecting the participating Microdot shareholders. The argument is that the terms "reorganization" and "recapitalization", found in Sec. 368(a)(1), really only encompass transactions that are tax-deferred events for shareholders. Microdot claims, therefore, that its 1975 exchange with its shareholders is eligible for original issue discount treatment under Sec. 1232(b)(2).

It is well to bear in mind that "[t]he propriety of a deduction does not turn upon general equitable considerations, such as a demonstration of effective economic and practical equivalence. Rather, it 'depends upon legislative grace; and only as there is clear provision therefor can any particular deduction be allowed.' " Commissioner v. National Alfalfa Dehydrating & Milling Co., 417 U.S. 134, 148-49 (1974) (quoting New Colonial Ice Co. v. Helvering, 292 U.S. 435, 440 (1934)). In short, the burden is upon Microdot to establish that a deduction for the transaction clearly has been provided for by Congress.

(A) The Statutory Provisions

I.R.C. Sec. 163 permits taxpayers to take as a deduction from adjusted gross income "all interest paid or accrued within the taxable year on indebtedness." As early as 1918, the IRS recognized that the aggregate difference between a bond issue's stated maturity price and initial cash price--the bond discount--was the economic equivalent of interest expense, and should be a permissible deduction. National Alfalfa, supra, 417 U.S. at 143-44 & n. 7. Such a deduction, however, was allowed primarily when the consideration paid for the bonds was cash. When the consideration was property other than money, the result was less certain. E.g., Nassau Lens Co. v. Commissioner, 308 F.2d 39 (2 Cir.1962) (deduction available); Montana Power Co. v. United States, 232 F.2d 541, 545 (3 Cir.) (en banc) (concurring views of Kalodner and Staley, JJ.) (deduction not available), cert. denied, 352 U.S. 843 (1956). For a discussion of the deductibility of debt discount in the context of a post-National Alfalfa case, see Cities Service Co. v. United States, 522 F.2d 1281, 1286-89 (2 Cir.1974), cert. denied, 423 U.S. 827 (1975).

This uncertainty was removed in 1969 with the enactment of the Tax Reform Act of 1969. Pub.L. No. 91-172, 83 Stat. 487 (1969). Congress at that time amended I.R.C. Sec. 1232 to provide explicitly that, upon a corporation's issuance of its own obligation for property other than cash, the difference between the stated maturity price and the issue price is deemed to be original issue discount.

I.R.C. Sec. 1232(b)(2) then defines the issue price of a bond exchanged for property other than cash. Note 1, supra. With two exceptions, the statute provides a general rule that, as long as either a portion of the bond issue is traded on an established securities market or the property received for the bonds is stock or securities traded on an established securities market, the issue price is the fair market value of the property received by the corporation. In the event one of the two exceptions is present, or neither of the conditions is satisfied, the issue price is deemed to be the equivalent of the stated maturity price. In such a situation, of course, when the difference between the two values is zero, there is no original issue discount.

The government argues that one of the exceptions is present in the instant case and therefore that there could be no original issue discount. The relevant exception is for "a bond or other evidence of indebtedness ... issued pursuant to a plan of reorganization within the meaning of section 368(a)(1)...." The title of I.R.C. Sec. 368 is "Definitions Relating to Corporate Reorganizations." Section 368(a)(1)(E) provides that "the term 'reorganization' means--... (E) a recapitalization." Note 1, supra.

(B) Defining Recapitalization

The term "recapitalization" is not defined in either the I.R.C. or the Treasury Regulations, although the latter list some examples of recapitalization, none of which is applicable here. Treas.Reg. Sec. 1.368-2(e) (1983). Under the predecessor to Sec. 368(a)(1)(E)--Int.Rev.Code of 1939, Sec. 112(g)(1), 26 U.S.C. Sec. 112(g)(1) (1952)--some construction of the term recapitalization was made which may be useful here. In 1942, the Supreme Court defined recapitalization as a "reshuffling of a capital structure, within the framework of an existing corporation." Helvering v. Southwest Consol. Corp., 315 U.S. 194, 202 (1942); accord, United Gas Improvement Co. v. Commissioner, 142 F.2d 216, 218 (3 Cir.), cert. denied, 323 U.S. 739 (1944); L. & E. Stirn, Inc. v. Commissioner, 107 F.2d 390, 391 (2 Cir.1939); Berner v. United States, 282 F.2d 720, 725 (Ct.Cl.1960); Seide v. Commissioner, 18 T.C. 502, 510...