Opinion ID: 330160
Heading Depth: 1
Heading Rank: 2

Heading: deductibility of debt discount

Text: 24 Debt discount typically results from the sale by an issuer of its debt obligation on the market at an issue price below the face amount of the obligation. The difference is referred to as the discount. 25 Although no provision of the Internal Revenue Code in so many words allows a deduction for debt discount, it is settled that such discount is amortizable and deductible over the life of the indebtedness if the debt obligation was issued for cash. National Alfalfa, supra, 417 U.S. at 143-46; Chock Full O'Nuts Corp. v. United States, 453 F.2d 300, 301-02 (2 Cir. 1971); Treas.Reg. § 1.163-3(a)(1) (1968). The Supreme Court has not decided the general question whether deductible debt discount results when bonds have been issued for property other than cash. National Alfalfa, supra, 417 U.S. at 146. The decisions of other courts on this issue are split. See cases cited id. at 146-47. Our Court, however, has held that such a deduction is allowable at least where the bonds were issued for tangible property. Nassau Lens Co. v. Commissioner, 308 F.2d 39 (2 Cir. 1962). 26 In the instant case, Cities issued new debentures for its own outstanding preferred stock. The face amount of these debentures equalled the aggregate of the stated value, accrued dividends and call premiums on the preferred. The government argues before us, as it did in the district court, that, since none of these items--excess of stated value over original consideration, 11 dividends or call premiums--would have been deductible by Cities had it paid cash for the preferred, to allow a deduction here would permit a taxpayer to convert non-deductible into deductible expenditures by the simple expedient of issuing debentures or bonds instead of paying cash for its preferred. 27 In effect, the government says that we must look at the transaction as if cash had been paid and the preferred had been redeemed. The district court rejected this analogy. 316 F.Supp. at 71. In view of the Supreme Court's decision in National Alfalfa, we agree with the district court and affirm its determination in this respect. 28 The corporate taxpayer in National Alfalfa issued 18-year 5% Sinking fund debentures, each $50 debenture to be exchanged for one share of outstanding $50 par 5% Cumulative preferred (callable at the time of the exchange at $51). The holder of each share of preferred also received a warrant to purchase one-half share of common at $10 per share in lieu of a $10 dividend arrearage on the preferred. The taxpayer claimed a deduction under Int.Rev.Code of 1954, § 163(a), 26 U.S.C. § 163(a) (1970), for amortizable debt discount measured by the difference between $33 per share, the asserted market value of the preferred on the date of the exchange, and $50, the face value of the debentures. The taxpayer urged the Supreme Court to look to the economic realities of the transaction to determine whether deductible debt discount resulted from the exchange. The taxpayer contended that, if it had gone into the marketplace and issued $50 debentures for $33 in cash and then had used those funds to purchase its outstanding preferred, it would have been entitled to a deduction for debt discount in amount of $17 per debenture. In rejecting this contention, the Court reasoned that: 29 (I)t would require rejection of the established tax principle that a transaction is to be given its tax effect in accord with what actually occurred and not in accord with what might have occurred . . . . 417 U.S. at 148. 30 Since the taxpayer in fact had not gone into the market and had not acquired the funds to purchase the preferred, the Court was unwilling to speculate as to what would have occurred had it done so. 31 The government's argument in the instant case is essentially the same as it urged in National Alfalfa. It asks us to view the exchange as if Cities had paid cash for the preferred and preference stock it received. But Cities would have obtained such cash only through the hypothetical venture into the marketplace which the Court rejected in National Alfalfa. Cash in fact was not paid here. We decline the government's invitation to postulate the tax consequences of the exchange on a hypothetical cash transaction which never occurred. 32 As Justice (then Circuit Judge) Marshall pointed out in Nassau Lens Co. v. Commissioner, supra, 308 F.2d at 44: 33 Surely a promise today to pay $150,000 in ten years is not presently worth $150,000 either in property or cash. 34 In the instant case, Cities in 1947 promised to pay $115,246,950 in thirty years plus 3% Annual interest. This promise cannot be equated with an actual cash payment of that amount in 1947. We hold that the tax consequences of the exchange must be determined on the basis of what actually occurred and not what might have occurred. Cummings v. Commissioner, 506 F.2d 449, 454 (2 Cir. 1974), cert. denied, 421 U.S. 913 (1975) (Smith, J., concurring). 35 We turn now to the government's more forceful argument based on what actually occurred here: the exchange of Cities' debentures for its outstanding preferred. This corresponds closely to what occurred in National Alfalfa. The Court's statement of the issue there is substantially what is before us here: 36 (W)hether debt discount arises where a corporate taxpayer issues a debt obligation in exchange for its own outstanding preferred shares. 417 U.S. at 147. 37 In National Alfalfa, the Court held that the transaction there involved did not result in debt discount deductible to the taxpayer. The government would have us read that decision so broadly that debt discount may never result from the exchange by a taxpayer of its debentures for its own outstanding preferred stock. We decline to do so. 38 In National Alfalfa, the Court focused on the economic similarity between bond discount and stated interest. It noted that there had been some confusion as to whether such discount was properly characterized as interest paid for the use of money or loss resulting from the funding operation. It concluded that the relevant inquiry in each case must be whether the issuer-taxpayer has incurred, as a result of the transaction, some cost or expense of acquiring the use of capital. 417 U.S. at 147. 39 The Court held that the taxpayer there had not incurred any additional cost for the use of capital by its exchange of $50 5% Debentures for $50 5% Preferred shares. The principal amount and interest rate on the debentures and the preferred were the same. The sinking fund provisions of both were comparable. The amount originally paid in for the preferred equalled the principal amount of the debentures--the ultimate obligation. The preferred was obtained merely by cancelling the $50 obligation per share on its equity account and transferring that amount to its debt account. As the Court observed: 40 The cost of the capital invested in the corporation was the same whether represented by the preferred or by the debentures, and was totally unaffected by the market value of the shares received at the time of the issuance of the debentures. Accordingly, while recognizing the alteration which did occur in the corporation's capital structure, we conclude that the substitution by (the taxpayer) of its debentures for its previously outstanding preferred, without more, did not create an obligation to pay in excess of an amount previously committed, or establish the base upon which debt discount can arise. 417 U.S. at 154. 41 The government argues here that Cities' balance sheet reflects a similar substitution. When Cities issued its new debentures and entered them on its balance sheet as debt, it cancelled in its equity account $58,690,000 representing the stated value of the preferred and $19,661,150 representing a reserve for dividends passed before 1938. The balance of the $115,246,950 face amount of the debentures resulted from a debit to its earned surplus account. The government says that all that occurred was a shift from Cities' equity account to its debt account and that no additional cost was incurred in retaining the old capital. 42 Cities argues, on the other hand, that it did incur additional cost since it became unconditionally liable to repay $115,246,950 for which it originally had received only $45,323,846. Although on the exchange the face amount of the debentures equalled the aggregate call price of the preferred, this amount did not represent a matured obligation of the company prior to the exchange since the exercise of the call option rested in the discretion and good faith of management. The preferred had no legal claim on the earned surplus for the difference before the exchange. They did have such a claim afterwards. 43 In National Alfalfa, the Court emphasized that the fact that a fixed obligation replaced an uncertain one was not alone enough to establish the additional cost required to give rise to deductible bond discount. The critical fact that distinguishes that case from the instant one is that all that occurred there was the substitution of one fixed $50 obligation for another. Moreover, the corporate taxpayer actually had received $50 in cash for the preferred at the time of its issuance. It neither paid nor obligated itself to pay more than the $50 it originally had received. To allow the corporation a tax deduction for repayment of any part of these funds--funds which it in fact had received--would have resulted in a windfall. 44 As we read National Alfalfa, the original consideration is the minimum value to be assigned to the preferred received in exchange for the debentures. 417 U.S. at 141-42. See Erie Lackawanna R.R. Co. v. United States, 422 F.2d 425, 430 (Ct.Cl.1970); Missouri Pacific R.R. Co. v. United States, 427 F.2d 727, 734 (Ct.Cl.), modified, 433 F.2d 1324, 1325-26 (Ct.Cl.1970), cert. denied, 402 U.S. 944 (1971). In short, where the original consideration equals the face amount of the debentures, no discount can arise since their issue price equals their face amount. 45 In the instant case, there is no such equality. The face amount of Cities' debentures far exceeds both the stated value of the preferred and the original consideration paid in at the time of issuance. In order to retain the use of the capital represented by it preferred and preference stock, Cities incurred an additional cost 12 through replacement of an uncertain (or perhaps non-existent) obligation, i. e. the stated value of the preferred, with a fixed one of greater amount, i. e. the face amount of the debentures. 46 To the extent that the district court below allowed a deduction for debt discount resulting from the exchange by Cities of its debentures for its own preferred stock and to the extent that the court specified the original consideration paid in for the preferred as the floor for determining the value of the debentures at the time they were issued, we affirm. 13