COMMISSIONER v. NAT. ALFALFA DEHYDRATING
Legal provision: Internal Revenue Code
Argument of Stuart A. Smith
Chief Justice Warren E. Burger: We’ll hear arguments first this morning in 73-9, Commissioner of Internal Revenue against National Alfalfa Dehydrating and Milling Co.
Mr. Smith, you may proceed whenever you’re ready.
Mr. Stuart A. Smith: Mr. Chief Justice and may it please the Court.
This income tax case comes here on a writ of certiorari to the United States Court of Appeals for the Tenth Circuit.
It involves the questions whether amortizable bond discount, which is deductible as interest under Section 163 of the Internal Revenue Code, arose out of a transaction accomplished by the respondent corporation in 1957.
Specifically, the transaction involved was an elimination of respondent’s outstanding $50, par 5% cumulative preferred stock, and a substitution for this eliminated preferred stock of an issue of $50 face amount, 5% bonds to be issued to the holders of the eliminated preferred on a dollar-for-dollar basis.
The detailed facts underlying this transaction are briefly as follows.
In 1957, respondent had two stock issues outstanding.
First, an issue of $1 par common stock; secondly, an issue of 47,059 shares of $50 par 5% cumulative preferred on which there were, in 1957, dividend arrearages amounting to $10 per share.
According to the certificate of incorporation, the preferred stock was redeemable according to a fixed downward sliding scale.
So that, in 1957, the redemption price was $51 per share plus the $10 dividend arrearages.
The preferred shares redeemed could not be reissued, but pursuant to provisions of the Articles of Incorporation, had to be canceled upon receipt or ultimately returned to the redeeming shareholders.
On April 8, 1957, respondent’s directors proposed a three-part plan which they characterized as a reorganization of the company by way of a recapitalization.
The three steps to the plan were as follows.
First, the directors proposed a series of three amendments to the Certificate of Incorporation.
Under the First Amendment, the preferred issue would be eliminated.
Secondly, the par value of the common would be increased from $1 to $3, and an authorization of the number of common shares would be increased from some 763,000 to 1 million shares.
Finally, the corporation was to be authorized to issue warrants for the purchase of common stock.
The second part of the plan involve the issuance of 18-year bonds bearing a stated interest rate at 5% and a $50 face amount to the holders of the eliminated preferred.
These bonds were to be subordinate to bank loans for inventory and to supply our obligations.
The bonds were to be redeemable at par plus accrued interest and, like the preferred stock for which they were to serve a substitute, they were subject to a sinking fund redemption provision.
Finally, the third step of the plan was to issue to the preferred shareholders a warrant enabling them to purchase common stock.
The terms of the warrant were enable the prefer-- the holders of the eliminated preferred to purchase one-half of a share of common stock at $10 a share.
This warrant was to be in lieu of the dividend the arrearages of $10 which existed in 1957.
The shareholders approved the plan and the focus of this case is on the second step of the plan.
That is, the issuance of bonds in substitution for the eliminated preferred stock.
A total of some $2 million of face amount bonds were issued which was exactly equal to the par amount of the eliminated preferred.
Thus, the capital of the corporation was reduced by some $2 million in the preferred stock account, and the bonds payable account was correspondingly increased by the same amount.
At the time of this transaction in 1957, there had been sporadic transactions involving, but a few hundred shares on an over-the-counter market of respondent’s preferred stock.
The price range of these transactions were bid ranging from $29 to $33 a share and an offering price of $32 to $35 a share.
Respondent claimed discount deductions for the $17 difference between the face amount of each bond issued, that is, $50 and the asserted fair market value of the preferred stock which was eliminated, that is, $33.
This case involves the propriety of that deduction.
Justice Potter Stewart: There’s no argument about the $33--
Mr. Stuart A. Smith: No, there’s no argument that-- well--
Justice Potter Stewart: -- of the accuracy of that figure?
Mr. Stuart A. Smith: Well, the accuracy of that figure is only questionable from the point of view of the sporadic nature of the transactions and since it only involved but a few hundred shares of the 47,000 shares outstanding, but for purposes of this case, there’s no argument that the fair market value could have been $33.
The Tax Court upheld the commissioner’s disallowance of the deduction in a unanimously reviewed decision, but the Tenth Circuit reversed with one judge dissenting.
In a series of decisions of this Court, this amortizable bond discount has been correctly recognized as essentially in the nature of interest.
And, this Court has also defined in numerous decisions “interest” as the compensation for the use of forbearance of money which has long been deductible under the Income Tax Acts and which is currently deductible under Section 163 of the Code.
The best way to understand how bond discount works, we believe, is by reference to the prototype transaction set forth in our brief at page 10.
In this prototype transaction, a corporation issues a bond with a face amount of $1,000 bearing stated interest at a rate of 5% over a 10-year term.
The bond is issued for $950.
The stated interest of 5% produces an interest obligation of 5% of $1,000 or $50 a year.
But because the issuer of the bond must pay back to the holder an additional $50 after the bond is retired, that additional $50 is also a cost of borrowing money and, as such, is deductible as interest.
Because it is payable over the term of the bond, this Court and appropriate treasury regulations have permitted a ratable deduction over the term of the bond or amortization, if you will.
Thus, the allowable deduction to the issuer on the prototype bond would be $55 a year and not $50 a year.
The critical question in this case is whether this transaction is analogous to the prototype transaction.
Here, we have a situation where the corporation issued a $50 debenture in substitution for a share of eliminated $50 par preferred stock.
There’s no question that respondent, upon the original issuance of the preferred stock, received $50 in the corporate teal, so to speak.
It has now transformed that preferred stock investment into a liability which will be payable over an 18-- at the end of 18 years.
It originally received this $50 and it now promises to pay $50 out over the end of the term.
This equivalence has been reflected in the journal entries of respondent which -- for they have reduced their capital account by the $50 par amount for each bond -- for each preferred stock share which has been eliminated and have increased their bonds payable account by a like amount.
This simple substitution of one security for another does not involve an obligation to pay in the future any more than the $50 originally received for the preferred stock.
And, we believe that as a matter of numerical equivalence there can be no discount in such a transaction.
Now, respondent and the Tenth Circuit have focused on these sporadic sales of the preferred shares at $33 a share.
It held that there was $17 of discount on the issuance of each debenture.
But, recalling that discount simply involves an obligation to pay in excess of an amount borrowed just as the corporation in the prototype transaction has promised to pay $1,000 although it has only borrowed $950, we submit that there is no such excess in this case.
For discount to exist in this case, the amount borrowed must be somehow analogous to the $33 in the same way that the $950 in cash is analogous to the amount borrowed in the prototype transaction.
But unlike the prototype transaction where the corporation has fully available $950 of cash for its use in the business, here, all respondent has is a certificate of its preferred stock which is immediately canceled by the terms of the Articles of Incorporation.
Thus, the so-called $33 fair market value of the preferred stock is meaningless to the respondent and in no sense, can it be said to have received $33 in a borrowing transaction.
Now, respondent disputes this analysis.
It argues that it only entered into this transaction because it did not have $33 in cash to redeem its preferred shares.
As a result, it had to issue bonds in the face amount of $50 and the argument goes that the $17 of excess is interest or deductible discount.
It analogizes its preferred shareholders through a so called financing medium, as it uses the term in its brief.
Justice Potter Stewart: What was the life of the bond?
Mr. Stuart A. Smith: The life of the bond here was 18 years.
Justice Potter Stewart: Eighteen.
Mr. Stuart A. Smith: But respondent’s argument assumes that it could have redeemed $33 for cash, but recalling that the preferred shareholders were entitled to a redemption price of $51 a share in 1957 plus the $10 of dividend arrearages, this is a $61 obligation per share to each preferred shareholder and not a $33 obligation.
There is no basis for inferring that the excess over the asserted fair market value of the preferred stock is a cost for the use of borrowing money.
Indeed, the inference that discount exists in this case becomes even weaker when we recall that the bonds themselves bore a stated interest rate of 5%.
Indeed, if respondent had redeemed the shares for cash at any price, the cases are clear that it would be entitled to no income tax deduction at all.
It therefore becomes apparent that it is simply absurd to infer a $17 deduction for deductible interest when the redemption price was possibly as much as $61.
Justice William H. Rehnquist: Well, what if the respondent had sold the bonds to third parties, gotten cash from them, and used the cash to redeem the preferred stock?
Mr. Stuart A. Smith: Mr. Justice Rehnquist, that kind of analogy was one of the basis of the reasoning of the court below and, we feel that it is simply a variation, as I will point out, of respondent’s financing medium argument.
The Tenth -- what the Tenth Circuit did was to analogize the transaction and to break it down into two elements: one, the issuance of a bond -- $50 face amount bond for $33 in cash and then the use of the $33 in cash to redeem the preferred shares.
The court claimed that, looking at the transaction that way, that there would’ve been discount as a result of the first aspect of the transaction, but this analogy, we feel, is erroneous from several different perspectives.
First of all, it is the transaction at issue here, the unified transaction which must be scrutinized and not a break down into what we regard as hypothetical nonexistent components, but there are also two factual misapprehensions about the analogy.
To begin with, it is entirely unsupported in the record to make an assumption that respondent could have reissued a $50 -- if it had issued a $50 bond in 1957, it would have only received $33 in cash, especially unsupported in view of the fact that the bond itself carried a stated interest rate.
But, as I’ve also pointed out, there is no basis for assuming that respondent could have redeemed its preferred shares for $33 in cash because the redemption price in 1957 was $61.
And if this $61 obligation was settled for $50 which got put on the face amount of the bond, there is no reason to infer that any part of that $50 is the cost of borrowing.
Now, even if respondent had --
Justice Potter Stewart: But there was no obligation on the part of the corporation to redeem, is there?
Mr. Stuart A. Smith: There’s no obligation -- there was no obligation.
Justice Potter Stewart: They could’ve redeemed at $61 --
Mr. Stuart A. Smith: They could have.
Justice Potter Stewart: -- under the sliding scale of that --
Mr. Stuart A. Smith: Yes.
Justice Potter Stewart: -- at that particular time.
Mr. Stuart A. Smith: Yes.
Justice Potter Stewart: There’s no obligation, unlike the maturity of the bond, there’s no obligation at all.
Mr. Stuart A. Smith: Right.
Justice Potter Stewart: What happened here was that each shareholder turned in a piece of property worth $33 in return for a $50 bond.
Is that right?
Mr. Stuart A. Smith: Worth $33, but --
Justice Potter Stewart: In the market?
Mr. Stuart A. Smith: In the market.
Justice Potter Stewart: In the marketplace?
Mr. Stuart A. Smith: Right, but not worth $33 --
Justice Potter Stewart: It was worth $61 because he had no right to compel redemption?
Mr. Stuart A. Smith: He had no right to compel redemption, but if redemption were to be affected as it was in this case, it had to be -- it could have -- the shareholders could have insisted on $61 per share.
Justice Potter Stewart: If had there been redemption?
Mr. Stuart A. Smith: Had there been redemption.
Justice Potter Stewart: But there wasn’t, there was an exchange --
Mr. Stuart A. Smith: Well, in exchange --
Justice Potter Stewart: -- of a piece of property worth $33, i.e. the preferred stock of the company, in return for a $50 bond bearing a 5% rate of interest in 18-year bond, is that it?
Mr. Stuart A. Smith: That’s correct, but --
Justice Potter Stewart: You don’t need to cut this thing and dichotomize it?
Mr. Stuart A. Smith: No, exactly and we feel that the Tenth Circuit, having done so, that it was error to have done that.
Justice Potter Stewart: You think it is error.
Mr. Stuart A. Smith: Because this was --
Justice Potter Stewart: Let’s assume it was error.
Just look at it as a unitary transaction in exchange of property worth $33 for a bond with a $50 face value and a 5% interest rate with an 18-year maturity.
Mr. Stuart A. Smith: Okay.
Well, if we look at it that way, the -- first of all, there was -- the corporation did not receive property worth to it $33 in the same way that the corporation, the prototype transaction, received an amount less than an amount which it obligated itself to pay in the future.
There was no excess -- obligation to pay an excess over an amount borrowed.
Here, the numerical equivalence is such that the corporation originally took in $50 for its preferred shares.
It has transformed that into a $50 liability and we believe that the $33 to have -- that the reference to the $33 asserted fair market value of preferred shares becomes irrelevant because this is simply a substitution of one security for another.
Justice Thurgood Marshall: It says the bookkeeping transaction?
Mr. Stuart A. Smith: A bookkeeping transaction in the sense that it is a reshuffling of one security for another, technically called a recapitalization.
Chief Justice Warren E. Burger: Well, they’re very different kinds of securities however, aren’t they?
Mr. Stuart A. Smith: They are different.
Chief Justice Warren E. Burger: One is debt and one is ownership?
Mr. Stuart A. Smith: They are different kinds of securities, but we don’t think that makes any difference in this case.
In fact, the similarities, Mr. Chief Justice, far outweigh the differences because just as the bonds was subordinate to supply our obligations in bank loans, the preferred shareholders were also subordinate -- could only get their $50 upon a voluntary liquidation of the corporation, so to speak.
So that, both really stood in somewhat the same position.
We think that the similarities far outweigh the differences.
Chief Justice Warren E. Burger: Well, but the relationship of the parties very drastically changed, did it not, from ownership to --
Mr. Stuart A. Smith: From a corporate point --
Chief Justice Warren E. Burger: -- from ownership to a debtor-creditor relationship?
Mr. Stuart A. Smith: That is from a technical corporate point of view, that’s correct.
But, we don’t think that should make any difference in this case where we have simply $50 going into the corporation through the par value of preferred stock.
There’s no dispute that the corporation received $50 and then it simply promises to pay $50 in the future.
Discount involves the existence of an obligation to pay something in excess of an amount borrowed and there was no obligation here to pay anything in excess of the $50 the corporation originally received on the issuance of its preferred stock.
Finally, the Tenth Circuit’s analogy becomes -- flies squarely in the face, we believe, of this Court’s decision in Great Western Power Company versus Commissioner, specifically held that such a substitution of one security for another is a unified transaction and not a transaction involving a breakdown of the issuance of the second one for the cash and the elimination -- and then the use of that cash to eliminate the first security.
Now, it seems to us that the Tenth Circuit misconceived the basic essentials of these transactions.
So, what we have here is simply the substitution of one security for another and we submit that a corporation’s issuance of debentures for stock is simply a capital readjustment that does not give rise, with those facts alone, to an inference of the existence -- for the existence of discount.
This -- thus, the $33 asserted market value of preferred shares becomes completely irrelevant.
And the correctness of this proposition, we believe, is amply demonstrated by two things in this case where you have a dollar-for-dollar exchange and where, as a matter of corporate mechanics, the corporation received nothing upon the exchange because the stock was immediately canceled.
Now, the Tax Court decided this case on the basis of a dollar-for-dollar exchange and in so holding, it followed the reasoning of a series of recent Court of Claims decisions which had also premised the nonexistence of discount in transactions like these on a dollar-for-dollar equivalence between the par value of the eliminated preferred stock and the face amount of the bond.
Now, we think while this rationale is certainly sufficient to reverse the judgment below, there are other ramifications of this problem which we believe this Court should consider in formulating a basis for its decision.
As I’ve said, as a general proposition, we do not believe that a capital readjustment of this type gives rise to amortizable bond discount.
Consider the situation of the corporation having issued a $55 face amount bond for the $50 preferred stock.
In such a situation, we still think that there is no basis for inferring bond discount.
Now, the Court of Claims has suggested and two District Courts have more explicitly held that discount might arise in such a transaction.
A District Court decision has proposed a formula for the measurement of discount in the following transaction which would be as follows.
It would measure the difference between the face amount of the bond in the example of $55 and the greater of the following two quantities.
First, the par value of the stock, here $50 or the value of the preferred stock to the corporation at the time of the exchange.
Now, under the District Court’s formula, the value to the corporation of the preferred stock may be greater than the par value of the preferred stock, but could in no instance be less than the par value.
Thus, for purposes of the example, under the District Court’s approach there could be as much as $5 of discount in this transaction in the $55 -- 50 transaction, but might be less.
Justice Potter Stewart: How would the value to the corporation be measured?
Would it be the $61 figure?
Mr. Stuart A. Smith: It’s not entirely clear, Mr. Justice Stewart, exactly what the District Court had in mind and that is one of our complaints about this test.
We think that the concept of value to the corporation introduces as vague and meaningless term.
Justice Potter Stewart: If they would’ve cost the corporation $61 in cash to redeem any one of these preferred shares as of the time of the conversion, would it not?
Mr. Stuart A. Smith: Yes.
Justice Potter Stewart: So I would suppose that would be the “value” to the corporation, that’s what it would’ve cost the corporation to get it.
Mr. Stuart A. Smith: On a redemption.
Justice Potter Stewart: Yes.
Mr. Stuart A. Smith: The problem with that kind of analysis is that --
Justice Potter Stewart: Although the corporation could go out in the open market and buy it for $33.
Mr. Stuart A. Smith: Yes, but as -- simply, as a matter of realistic market mechanics, I would assume that if the corporation here attempted to buy up as many shares as it could on the open market --
Justice Potter Stewart: I know.
Mr. Stuart A. Smith: -- it’s intention to retire the whole issue would’ve become apparent and the market price would’ve been pushed up toward the redemption price.
Justice Potter Stewart: But you don’t understand, in other words, what the court meant by the alternative.
Mr. Stuart A. Smith: Well, it’s not entirely --
Justice Potter Stewart: Either the -- it’s either the par value, assuming that par value had been the true amount paid in capital, or you say alternatively the value to the corporation and your representation is you don’t understand what that means --
Mr. Stuart A. Smith: Well, I don’t think the courts quite understand what the value to the corporation means because the Court of Claims has suggested that fair market value of the preferred stock is a relevant consideration for determining the value to the corporation, but it is not a determinant consideration.
Thus, it seems that the courts know that they want to get away from this approach once they get away from fair market value which, of course, we also contend is erroneous, but it’s not clear to the courts exactly what this term “value to the corporation” is.
Now, whatever it is, we submit that there still is no basis for an inference that discount arises in such a transaction.
To begin with, if the term “value to the corporation” means what the corporation would be willing to pay for the preferred stock, then even under the District Court’s formula there would be no discount because there would be a face amount of $55 for the bond and the corporation would be willing to pay $55 for the stock.
Thus, there would be no element of that $50 -- $55 figure would constitute a cost of borrowing.
Indeed, there are many instances which we might call to mind to suggest why a corporation would be willing to purchase its preferred stock for more than its par value.
There could be a call premium, or whatever, which might force the corporation to be required to pay from its shareholder more than the par value of the stock.
So, if that value to the corporation means the price at which the corporation pays for the stock, there would be no discount.
But, even conversely, if the face amount of the bond represents somewhat more than the corporation would be willing to pay for the stock, there is still no reason to infer the existence of discount.
There are varieties of other corporate reasons completely unrelated to the cost of borrowing money which could form a basis for understanding why a corporation would enter into a transaction like this.
For example, in this very case, respondent could have -- respondent wanted to eliminate the dividend arrearages.
It could’ve decided that it wanted to transform nondeductible dividends on preferred stock into deductible interests.
It could’ve decided it wanted to eliminate the preferred shares which were held by a dissident group.
In any event, we submit that there are varieties of other independent reasons which would form the basis of a decision why a corporation would be willing to pay more for its preferred stock than the so-called market value or its value to the corporation which are totally unrelated to the cost of borrowing money.
Justice Potter Stewart: What voting rights, if any, did the holders of the preferred shares have?
Mr. Stuart A. Smith: They did vote as a class and, in fact, voted on this very plan.
Justice Potter Stewart: Share-for-share with the common shareholders?
Mr. Stuart A. Smith: I think as -- I think, simply, it was a much smaller class.
I think it was share-for-share.
I’m not exactly sure.
Justice Potter Stewart: Many if you’re par view of shares.
Mr. Stuart A. Smith: Yes, par view of shares.
Justice Potter Stewart: And no increase in voting power when there were arrearages?
Mr. Stuart A. Smith: No, not that I’m aware of.
I see that I have little time left.
I would like to save it for rebuttal if the Court has no further questions.
Chief Justice Warren E. Burger: Very well, Mr. Smith.
Argument of Charles White Hess
Mr. Charles White Hess: Mr. Chief Justice and may it please the Court.
My name is Charles Hess.
I’m an attorney from Kansas City, Missouri and with the firm of Lindy, Thompson, Van Dike, Fairchild, and Langworthy.
We have represented the respondent National Alfalfa Dehydrating and Milling Co. for many years and have represented them throughout this litigation.
Mr. Smith’s presentation of the facts has been relatively accurate.
However, we cannot agree with the facts which he emphasizes nor with his characterization of the redemption or exchange transaction which occurred in this case as a substitution of securities.
In its simplest form, National Alfalfa issued a $50 face amount 5% debt obligation, repayable in 18 years to its preferred shared holders in exchange for or redemption of each share of their preferred stock which had a fair market value of $33 at the date of the exchange.
The preferred share holders retained no further equity interest in the corporation.
The economic reality surrounding the exchange, which are substantiated in the record, dictated that the issue price of each debenture was $33 or the fair market value of the preferred stock.
And, that the difference of $17 between the face amount of the debenture and its issue price of $33 represent a discount.
The economic facts surrounding the transaction which dictated that $33 was the true and meaningful value to be attributed to the issue price of the debentures are numerous.
The preferred stock for which each debenture was issued had a fair market value in the over-the-counter market of $33 per share.
Justice Mr. Justice Blackman: Is that stipulated?
Mr. Charles White Hess: Yes, it was a stipulated fact in the Tax Court.
Justice Mr. Justice Blackman: Did they stipulate to the extent that it would’ve been possible to purchase it on a market at that figure or just that it had a value?
Mr. Charles White Hess: There are two or three exhibits.
The stipulation refers to the exhibits.
One is the National Stock Summary which summarizes the activity in over-the-counter stocks and it’s used by the Internal Revenue Service for estate evaluation, that type of thing.
And, we have all of the bid and ask -- and exchanges is made during two or three months around July of 1957.
The other exhibit is a letter from Francis I. DuPont which was the chief market maker in the stock at that time quoting the bid and ask prices on 10 days either side of the date of the exchange.
And the stipulation refers to this and states that the value was $33.
In addition to the preferred being worth $33 in the market, there were four years of dividend arrearages on the preferred.
National’s credit rating was so poor at that time that it could not borrow sufficient funds from banks to finance inventory requirements for its operations.
National’s balance sheet and operating statement, which are reflected in the Tax Returns which are exhibits in our record, reflected that its prefer -- reflected that its overall financial picture was very poor.
It did not have sufficient cash or liquid assets to redeem the preferred for $33 in cash.
The fact that the preferred shareholders were to be removed by this redemption as equity owners in National through the redemption meant that the negotiations preceding the exchange and the exchange itself were arm’s length dealings, taking into account the relative positions of each of the preferred shareholders at the time of the exchange.
The ruling letter issued by the Treasury prior to the exchange properly describing the exchange as a redemption and requiring the recognition by the preferred shareholders of gain or loss on the exchange clearly acknowledged the arm’s length dealing inherent in such an exchange which took into account the economic status of the parties at that time.
Judge Phillips for the Court of Appeals recognized the economic realities existing in the transaction which lead him to the proper conclusion that the debentures were issued for $33 and that the $17 difference was interest in the form of discount.
He recognized that the financial status and negotiating position of the parties in 1957 and the then current value of the preferred stock determined the face amount, the stated interest rate, and the discount on the debentures.
All of which are variable factors depending upon the circumstances of any given exchange.
Justice Mr. Justice Blackman: Mr. Hess, I suppose if National Alfalfa had actually done that, gone out into the market and done what was supposed, you wouldn’t be here, there’d be no case?
Mr. Charles White Hess: That is true.
Justice Mr. Justice Blackman: Of course in tax law we have a lot of distinctions and cases depending on what actually was done, not on what might have been done, but you feel that what might have been done equates with what was done?
Mr. Charles White Hess: Very much so.
I think his analogy, although it sets up slightly different facts, really explains the economic realities of what happened.
If National had done that, I’m not sure exactly what would’ve happened.
They may not have been able to sell their debentures for $33 cash.
The discount may have been greater.
There’s no guarantee that, in the marketplace, that they could’ve gotten $33.
They might have gotten $25 and we’d have been asking for deductions for $25 instead of $17.
Justice Mr. Justice Blackman: Your Tax Court decision was reviewed by the Full Court, wasn’t it?
Mr. Charles White Hess: Yes.
Justice Mr. Justice Blackman: It’s a little surprising you didn’t pick up somebody in your favor among that array of tax judges.
Mr. Charles White Hess: The -- in all of the cases that had been cited on the variant issues here, the Court of Claims and the Tax Court are the only ones that had gone this direction.
The Courts of Appeals have gone the other way, the various Circuit Courts of Appeal.
And, I think that they’ve just gotten -- they got off on wrong intention and I can’t explain that, their decision, I think it’s wrong.
They purposely refused to follow the decision of the Court of Appeals of the Tenth Circuit in (Inaudible) and Santa Fe case which was a decision that was made in 1970 which allowed bond discount in a railroad reorganization situation.
Justice Mr. Justice Blackman: Of course the Tax Court’s been wrong before.
You hope they’re wrong again.
Mr. Charles White Hess: Right, I sure do.
Justice William H. Rehnquist: Mr. Hess, in the real world of finance, are there many debentures with the face value of $50 that you would market for $25?
I mean, is this something that happens with any frequency?
Mr. Charles White Hess: I’m not sure that I have the background to tell you that.
I do know that from the calculations that Judge Phillips made, the actual dollar effect of this was that an additional 1.9% interest would be added to the stated interest rate of 5%.
So although the discount in terms of $17 on $50 sounds high, if you recognize it in the form of 6.9% total interest, that’s not all that high.
Justice William H. Rehnquist: Then a $5 discount, say $50 or $45 or $30, has just really a very insignificant effect on the stated interest rate if $17 would have that small?
Mr. Charles White Hess: Yes, I can’t calculate quite that fast, but I assume it would be much smaller than 1.9%.
It might be 0.5, it might bring it up to 5.5.
Justice Potter Stewart: But you get a very substantial discount sometimes depending upon the stated interest rate in the debenture.
I mean, if it were 2%, say the debenture compared to today’s interest rates, there would be a tremendous discount and, plus the condition of the issuer.
I mean, a debenture, by definition, is an unsecured -- basically, unsecured debt obligation as contrasted to a bond.
And, that could amount to -- you could get a very substantial discount in that area of magnitude.
Mr. Charles White Hess: The discount will vary directly with the stated interest rate, it’s one factor and --
Justice Potter Stewart: Stated interest rate and the secure --
Mr. Charles White Hess: Condition, right.
Justice Potter Stewart: -- and the strength of the issuing company, the financial strength.
Mr. Charles White Hess: And National, at this time, was not strong.
Judge Phillips noted that the preferred shareholders were acting as a financing medium to the extent of the $33 of actual value of the debentures received by them, an amount which National did not have in cash to pay them.
Now underlying these economic facts, the Court of Appeals understood that the preferred shareholders upon receiving the debentures became creditors and that National’s relationship to them after the exchange was entirely different than before.
First of all, there was the requirement for repayment of $50 at the maturity in 18 years.
Secondly, there was a fixed interest payments that had to be made.
The default provisions of the indenture exposed National’s assets in the event that the interest or principal were not paid.
Restrictions in the indenture prohibited numerous financing in operational activities of National, and the establishment of and payments to a sinking fund further protected the debenture holders.
In fact, the sinking fund was used entirely properly.
It was funded at every point that it was supposed to be funded and the debentures have been retired in proper order.
Now, in contrast to the economic analysis approach in our case which the Court of Appeals took, the Erie Lackawanna case which is a Court of Claims case takes an historical approach and it was mentioned by Mr. Smith.
Now, Erie Lackawanna, being a Court of Claims decision, is the corner stone of all of the cases supporting the commissioner’s position, in this case and from which he has attempted to develop some theory which would prevent the use of fair market value of the preferred as the issue price of the debentures.
The dissent in our case relied on the rationale of the Erie case.
But the approach used in Erie has been termed the arithmetical equivalence theory or the numerical equivalence theory which Mr. Smith used today.
Basically, it is -- that approach is that since $50 was originally received upon issuance of the preferred by National and, ultimately, many years later, National will pay $50 to a debenture holder, then the corporation has not been hurt.
The total inadequacy of this arithmetical equivalence approach is three-fold.
First, it ignores the basic qualitative differences between debt and equity instruments.
Namely, the $50 face amount on the debentures must be paid back.
The $50 par on the preferred is never required to be paid back.
The debentures appear as a long-term liability on the balance sheet.
The preferred -- the interest of the preferred holders appears in a stockholder’s equity account and these entries reflect the basic transformation that occurs in an exchange.
The debenture holder is a creditor and not an owner.
He has no residual interest in the corporation or its profitability.
He has no voice in corporate policy and, he takes no risk.
None of these are true with the preferred.
The arithmetical equivalence theory also ignores the economic reality surrounding exchange.
In spite of the fact that the economic facts at the date of the exchange determine the elements of consideration given by each of the parties to the exchange, the amicus Norton Simon set forth a hypothetical which I think is very appropriate in showing the impropriety of this arithmetical equivalence theory.
If National’s preferred had been $10 par, but the fair market value at the date of the exchange was $50 and National went ahead and issued a $50 face amount debenture for the preferred, under the Erie Lackawanna case and the arithmetical equivalence theory, we would be entitled to a deduction or discount of $40, the difference between the $50 face amount of the bond and the $10 par value of the preferred.
Obviously, this is not right.
We would be giving up a face amount debenture worth $50 and receiving something of -- with a fair market value of 50, and I think these points out the weakness of that arithmetical equivalence theory.
Now, the arithmetical equivalence theory finds no support in the Internal Revenue Code sections dealing with bond discounts.
In analyzing the appropriateness of National’s deduction for interest in the form of discount, you must realize that the Internal Revenue Code contains counterparts of the interest deduction for amortized bond discount.
These provisions provide the symmetry to the text elements of a transaction normally found in the Internal Revenue Code.
The debenture holder reports the interest which is in the form of discounts as ordinary incomes.
If a corporation repurchases its debentures in the market at less than face value, which National did in this case, the difference between the face value and the lesser price paid in the market is reported as ordinary income by the corporation on its tax returns.
If, for policy reasons, the commissioner or others such as the court in Erie feel that a corporation should not obtain a deduction for discount in a case such as this where it is clearly authorized by the codes and sections dealing with interest deductions and where it is clearly supported by the economic facts in the situation, then we believe that the place for them to look is to Congress.
However, it may be too late at this point because Congress in the 1969 Tax Reform Act resolved this problem for the future and, we believe, did so in a manner consistent with the decision of the Court of Appeals in this case.
The Court of Appeals' decision in this case was appropriate.
Respondent respectfully requests that the decision of the Court of Appeals for the Tenth Circuit be affirmed.
Thank you very much.
Chief Justice Warren E. Burger: Thank you Mr. Hess.
Do you have anything further, Mr. Smith?
Rebuttal of Stuart A. Smith
Mr. Stuart A. Smith: Just a few points.
Mr. Justice Blackman asked about the fair market value of the preferred stock.
The reference in this stipulation in the Tax Court is at page 27 of the record, paragraph 13.
There was no stipulation between the parties with respect to fair market value.
All the stipulation says, is attached hereto and marked as Exhibit 17, is a letter from Francis I. DuPont and company in which the bid and ask range prices are quoted.
That’s the only thing in the record with respect to the fair market value of the preferred stock.
Justice William H. Rehnquist: Did government put in any evidence contradicting that?
Mr. Stuart A. Smith: No, because from our point of view the fair market value of the preferred, whatever the fair market value of the preferred stock, doesn’t --
Justice William H. Rehnquist: Didn’t make any difference?
Mr. Stuart A. Smith: -- Doesn’t make any difference.
Since discount involves an obligation to pay an amount in excess of an amount borrowed, we don’t think that there was anything in excess of $50.
With respect to the similarities and difference -- alleged differences, between the preferred stock and the debentures, let me just refer the Court to the discussion on pages 14 and 15 of our brief in which it is pointed out that both the preferred stock and the debentures were both subject to comparable sinking fund provisions which would retire both of them.
I think that simply, as a matter of realism, both the preferred shareholders here and the debenture holders were both subject to the risk of the business.
If the business didn’t make any money, then the debenture holders wouldn’t get paid nor would the preferred shareholder’s investment really be worth anything.
I think in closing, what I simply want to emphasize is what the taxpayer is arguing for here is an automatic rule which would insist upon the existence of discount between the face amount of the debenture and the asserted fair market value of the preferred stock.
We say, on those facts alone, there is no basis for inferring discount and that the basis of the lack of discount is graphically illustrated in this case by the equivalence between the par value of the preferred stock and the base amount of the debenture.
The corporation took in $50 and promised to pay out no more than $50 over the end of the term.
But simply, if the corporation had increased the face amounts of the debenture, we do not think -- it’s $55, we don’t think that there is a basis for inferring the existence of discount.
We think that the taxpayer should be put to the burden of demonstrating that that excess really represents the cost of borrowing and that since that there are a variety of reasons why a corporation would want to enter into a transaction like this -- I see my time is up, I’ll just finish my sentence, we think that those reasons should control unless there is strong evidence inferring an additional cost of bond.
Justice Lewis F. Powell: Mr. Smith, may I ask you a question.
Do you attach any significance to the 1969 amendment to the code argued in the amicus briefs and also --
Mr. Stuart A. Smith: We do not think --
Justice Lewis F. Powell: -- in your reply brief?
Mr. Stuart A. Smith: We have filed the reply brief, Mr. Justice Powell, which discusses this point.
Briefly, we do not attach any significant -- any really significance to the 1969 amendment.
But, we do note that the approach of Congress in 1969 is parallel to the approach we would take in this case.
That, as a general rule, when a corporation issues bonds for property, Congress has declared in 1969 that the issue price is equal to the face amount of the bond with only two exceptions, that either the bonds be traded on a public exchange, or that the stock be traded on a public exchange.
Neither of those facts exists in this case, and we think that the general rule without the exceptions lend support and is parallel to the approach we take here.
Chief Justice Warren E. Burger: Thank you, Gentlemen.
The case is submitted.