United States v. Corporation

• Decision Date: 03 May 1965
• Docket Number: No. 628,MIDLAND-ROSS,628
• Parties: UNITED STATES, Petitioner, v. CORPORATION
• Court: U.S. Supreme Court

381 U.S. 54

85 S.Ct. 1308

14 L.Ed.2d 214

UNITED STATES, Petitioner,

v MIDLAND-ROSS CORPORATION.

No. 628.

Argued March 31, 1965.

Decided May 3, 1965.

Frank I. Goodman for petitioner.

Theodore R. Colborn, Cleveland, Ohio, for respondent.

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 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, 85 S.Ct. 441, 13 L.Ed.2d 542. 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

'not everything which can be called property in the ordinary sense and which is outside the statutory exclusions qualifies as a capital asset. This Court has long held that the term 'capital asset' is to be construed narrowly in accordance with the purpose of Congress to afford capitalgains treatment only in situations typically involving the realization of appreciation in value accrued over a substantial period of time, and thus to ameliorate the hardship of taxation of the entire gain in one year.' Commissioner v. Gillette Motor Transport, Inc., 364 U.S. 130, 134, 80 S.Ct. 1497, 1500, 4 L.Ed.2d 1617.

See also Corn Products Co. v. Commissioner, 350 U.S. 46, 52, 76 S.Ct. 20, 24, 100 L.Ed. 29. In applying this principle, this Court has consistently construed 'capital asset' to exclude property representing income items or accretions to the value of a capital asset themselves properly attributable to income. Thus the Court has held that 'capital asset' does not include compensation awarded a taxpayer as representing the fair rental value of its facilities during the period of their operation under government control, Commissioner v. Gillette Motor Transport, Inc., supra; the amount of the proceeds of the sale of an orange grove attributable to the value of an unmatured annual crop, Watson v. Commissioner, 345 U.S. 544, 73 S.Ct. 848, 97 L.Ed. 1232; an unexpired lease, Hort v. Commissioner, 313 U.S. 28, 61 S.Ct. 757, 85 L.Ed. 1168; and oil payment rights, Commissioner v. P. G. Lake, Inc., 356 U.S. 260, 78 S.Ct. 691, 2 L.Ed.2d 743. Similarly, earned original issue discount cannot be regarded as 'typically involving the realization of appreciation in value accrued over a substantial period of time * * * (given capital gains treatment) to ameliorate the hardship of taxation of the entire gain in one year.'

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, 60 S.Ct. 363, 368, 84 L.Ed. 416; 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 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, 313 U.S., at 31, 61 S.Ct., at 758. 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 1954⁵ provides that 'upon sale or exchange of * * * evi- dences 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, 82 S.Ct. 1080, 8 L.Ed.2d 187; Deputy v. du Pont, supra; cf. Helvering v. R. J. Reynolds Tobacco Co., 306 U.S. 110, 59 S.Ct. 423, 83 L.Ed. 536. But the taxpayer must persuade us that this was clearly the case, see Watson v. Commissioner, supra, 345 U.S., at 551, 73 S.Ct., at 852, 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 capi- tal 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 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 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 Code⁸ 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, 53 S.Ct. 337, 77 L.Ed. 739. Moreover, the Com- missioner 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...