Dixon v. United States – Oral Argument – March 30, 1965

Media for Dixon v. United States

Audio Transcription for Oral Argument – March 31, 1965 in Dixon v. United States

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Earl Warren:

Number 486, W. Palmer Dixon et al., Petitioners, versus United States.

Mr. Brandes.

Bernard E. Brandes:

May it please the Court.

This case is before the Court on certiorari to the Second Circuit.

There are two issues involved and the first of the two issues, the same issue is involved in the companion case of the Midland-Ross Corporation in which the government is the petitioner.

That case follows immediately after this case.

So far as the first issue was concerned, the facts are relatively simple.

The year involved is the year 1952 and accordingly the provisions of the 1939 Internal Revenue Code apply.

In that year, the petitioner’s here were members of the partnership engaged in the business of dealing in securities.

In addition, the partnership from time to time purchase securities for its own account as principal.

In early nine — commencing in early 1952, the partnership purchased certain securities consisting of promissory notes that had been issued at a discount and did not bear interest.

It is conceded that these securities were properly identified and marked for investment as is required of a deal of in securities so that they constituted in the hands of the partnership, capital assets.

These securities were sold after — certain of these notes were sold in 1952 after they have been held for more than six months.

And the gain on the sale was reported by the partnership and therefore by the petitioners as a long-term capital gain.

On audit, the Internal Revenue Service held that the gain which had been reported on sale as long-term capital gain was in reality interest income and so far as the notes which as of the end of the year had not yet been sold, as to those notes even though they had not yet been sold, there was a requirement for a picking up on a pro rata basis of the discount at which those notes had been issued.

The first issue is therefore a very narrow confined issue with statuary construction under the 1939 Code.

It is an issue that does not exist in the context of this case under the 1954 Code because as we propose to develop the law that has been changed.”

Properly stated was, the issue is very simple, what under the 1939 Code was the status of issue discount and to what is the answer to that question is to be determined only in the light of the words of the statute as written, in the light of a demonstrated intent of Congress and in the light of such precedent as we have on the issue and so far as precedent is concerned, the only precedent close to this issue consists of decisions of this Court.

Now, in the court below and continued here, the respondent has offered a very simple, disarming approach to the issue.

The respondent’s approach basically is, discount is like compensation for the use of money.

Interest is also compensation for the use of money.

Accordingly, discount and interest must be related and the measure involved of compensation for the use of money must be the measure of ordinary taxable income in the nature of interest that must exist.

Now, this approach which I have taken the liberty of terming it a simple and disarmingly simple approach was fully accepted by the court below and so far as we can ascertain from the opinion, the Court did not proceed to examine what it is that we there offered and there offered again by way of material that shows that Congress was aware, that obligations were issued at a discount and was aware that the tax treatment which attached to obligations that were issued at a discount were different.

Further —

Potter Stewart:

These were the notes, promissory notes?

Bernard E. Brandes:

Yes sir.

Potter Stewart:

Purchased from the obligor, from the maker?

Bernard E. Brandes:

In some instances from the maker and in other instances from other dealers.

Potter Stewart:

On the date of issue or —

Bernard E. Brandes:

In all as I remember about one instance on the date of issue.

Potter Stewart:

And in 1952 and then these sales were also within the calendar year 1953?

Bernard E. Brandes:

These sales were within the calendar year 1952 as to certain of the notes which were thus purchased.

Potter Stewart:

Well, and the only — that’s the only income in question in this case, is it, 1952?

Bernard E. Brandes:

Well, in 1952 is the only year before the Court.

However, on audit of 1952, the Internal Revenue Service reclassified the gain on the sale of the notes which were sold.

And in addition, with regard to the unsold notes on the ground that the discount which had been accumulating on those unsold notes, was ordinary income in the nature of interest they forced in accrual.

Potter Stewart:

These are accruals experience appropriate (Voice Overlap)

Bernard E. Brandes:

These are accruals — the partnership is an accrual basis taxpayer.

Potter Stewart:

And it’s not – I probably should know this, but I don’t know if the partnership of course is not itself a tax payer.–

Bernard E. Brandes:

Right sir.

Potter Stewart:

— but a reporter of a return —

Bernard E. Brandes:

The partnership files an —

Potter Stewart:

And if — if the partnership is on the accrual basis, does this automatically put all the partners on the accrual basis?

Bernard E. Brandes:

No sir.

We thought —

Potter Stewart:

Not such as the business — as to that part of the income account, a very income account in the partnership or not?

Bernard E. Brandes:

The individuals are not on the accrual basis, but they must pick up in their individual returns, what it is that the partnership return shows as their share of income (Voice Overlap).

Potter Stewart:

Even though they’d be on a cash basis?

Bernard E. Brandes:

Even though they’d be on the cash basis.

Potter Stewart:

That’s — what about your —

Bernard E. Brandes:

The partnership return is just an information —

Potter Stewart:

I understand — I know that.

Bernard E. Brandes:

— that discloses what it is that each of the partners must report.

Returning to this approach based on compensation for the use of money, although it involves the anticipating part of our argument here, because it is so fundamental to our position to point out and to have the Court realize that the measure of compensation for the use of money is not the measure of interest.

I should like at this point to refer the Court to its decisions in the Bond Premium cases.

Just as that obligation is issued at a discount, it is issued at a premium.

This Court has upheld the treasury in holding that the amount of premium paid does not reduce the amount of interest yield on the obligation, unless there is special legislation.

In other words, if an investor holds an obligation which he acquired at a premium, he is required to pick up and report the full amount of the interest yield without reduction for the premium, unless there is special legislation which authorizes the amortization of the premium, which special legislation came into being in 1942 —

Byron R. White:

And then yield within the technical sense?

Bernard E. Brandes:

Pardon me sir.

Byron R. White:

Are you using a yield in any technical sense or are you just using it to —

Bernard E. Brandes:

Yield in the —

Byron R. White:

— in the returns that he had —

Bernard E. Brandes:

— in the economic —

Byron R. White:

He must —

Bernard E. Brandes:

— or the investments.

Byron R. White:

He must return all the interest that you’d paid to him?

Bernard E. Brandes:

Right sir, without any reduction.

Byron R. White:

It maybe different than yield.

Bernard E. Brandes:

Well, or — if you use the terminology of yield, then all the interest that is paid to him is not the yield.

Byron R. White:

That’s right.

That’s alright, and then that isn’t what you mean.

Do you mean that he has to return all the interest you’d paid to him?

Bernard E. Brandes:

Right.

Turning to what we believe that we are in a position to prove with regard to the intent of Congress in connection with the 1939 Code as in support of our position that under the 1939 Code, unlike under the 1954 Code, issue discount is a capital item.

We should like to refer to the structure of the statue to the fact that there were specific provisions of the statue which should have been superfluous.

If the rule is as respondent contends namely, if the rule is that issue discount is always an income item.

We also — to demonstrate the state of the lower pride to the 1954 Code will show that the administrative practice existing at least prior to 1953 was to regard issue discount as a capital item.

The capital gains and losses provisions of the 1939 Code are very clear.

They define capital assets and they further define that any gain realized on the sale of a capital asset is a capital gain and that it is true, is as far as they go and there’s — in that connection.

Within that framework if we went no further, it would be very difficult to find why.

This discount when realized on sale should not be a capital gain.

There was a sale and there was a profit and it was realized after six months.

If we are to believe that there are some hidden, ipso limitations on the definition of what constitutes a capital gain, it is most material to observe that within the framework of Section 117, which is the pertinent Section, the Congress has inserted a very explicit exception.

Securities that have been — short-term securities that have been issued at a discount and without interest, the statue goes on to say.

By any government, do not constitute capital assets by excluding them from the definition.

Congress saw to it that any gain on those securities was ordinary income.

Now, it is true that the respondent has come forward with some explanation of the background of that section of the statue.

But the fact remains that the existence of this section of the statue shows that the Congress was in a position and knew how to deal with issue discount under the 1939 Code, when it was faced with the need so to deal with issue discount under the 1939 Code.

There were other examples as specific enactments dealing with issue discount that should have been superfluous, if the rule under the 1939 Code was as is contended.

Bernard E. Brandes:

There are special provisions in Section 207(d) and 207(e) dealing with certain insurance companies and specifically requiring those certain insurance companies to accrue and report is ordinary income discount and on the counter balance to accrue and report by way of reduction of ordinary income on premium.

Going back into the legislative history, we find specific statements in the Congress wherein they displayed their understanding and awareness of the fact that debt obligations were issued at a premium under the discount and that different — were being issued with expressed interest under the discount and that different tax consequences attached to the different types of obligations.

We have at some length delved upon the Senate debate in 1929.

This debate was occasioned by a proposal which authorized the issue of treasury bills at a discount.

At that time, interest on U.S. obligations was exempt from the tax.

It was recognized that to make the treasury bills competitively saleable, there had to be some exemption factor attached to them.

The proposal of the treasury and accepted by the senate finance committee was to attach the exemption factor by providing in the statue that all gain on the sale or rather disposition of these bills should be exempt from tax.

The debate in the Senate shows that there was considerable opposition to such a proposal, because it was felt that there should not be any weakening of the structure which required all capital gains to be subject to tax.

The debate in the senate further shows that the senate was fully aware of the fact that the discount at which these bills were being issued represented to use the words of Senator Reid “Hire for the use of money” and further demonstrates that the Senate believes because it had been so advised by the treasury that under then existing regulations of the treasury, discount, issue discount when realized would be taxed as capital gain.

And accordingly, the exemption for interest which then existed pertaining to obligations of the United States could not apply to a treasury bill.

The Congress again displayed the great awareness of the situation by carving out the discount, by specifically legislating that the discount shall be labeled and classified as interest.

And in that way, the Congress permitted to be attached to the discount at which these bills were issued, the exemption then applying for interest.

In 1938, there was a subcommittee appointed as a part of the study leading to 1939 Code.

This subcommittee considered whether or not to eliminate the capital gains tax.

Because time is running out, I cannot now read to you the excerpt from this committee’s report, but I should like to refer You Honors to it.

It is on, page 15 of my brief, and clearly again shows that the Congress was aware of the practice and was aware of the different tax results that existed.

I have no place in the respondent’s paper been able to find any statement by respondent, that his practice was other than during this period prior to 1953, 1952 and prior, other than to treat issue discount as capital gain.

We have in our papers, references to the acquiescence which stood through five major legislative overhauls in a case which held that issue discount when realized was capital gain.

At the very beginnings of 1952, there was a special ruling issued in publishing the tax services, which again repeated respondent’s position that issue discount when realized was taxable as a capital gain.

Now, it’s true that the statue was changed in 1954.

However, I invite the Court’s attention to the structure of the statue.

It is as clearly as prospective an application as any statue could be.

It applies only to obligations issued after December 31, 1954, and that although the statue itself was passed in August of 1954.

Furthermore, in one specific instance, in Section 1232, where they wanted to change the existing rules, they have yet another effective date of March 1954.

In connection with the enactment of the 1954 Code, the House Ways and Means Committee clearly stated that this is a change in the law that under the prior law issue discount was taxed when realized as a capital item.

With regard — I have mentioned the situation with regard to bond premium and there legislative history was the same.

The situation is to bond premium to bring up more in line with concepts of finance and economics was corrected in 1942.

The respondent’s answer here apart from the argument to which I have referred is primarily that discount is deductible to the issuer.

Now, I can’t find that that is an answer to the problem because as regards premium, premium has always been an item of increase to the issuers income even at the time when it was not an item of decrease to the holder’s income with regard to the obligation.

In summary so far as this first point —

Potter Stewart:

Discount is deductible to the issuer?

Bernard E. Brandes:

Yes sir.

Potter Stewart:

From his ordinary income whether or not his on the accrual basis?

Bernard E. Brandes:

Under the regulations of the treasury, it must be amortized over the life of the security.

Potter Stewart:

What ever his basis is?

Bernard E. Brandes:

Right.

Potter Stewart:

I mean whether it’d be cash or accrual?

Bernard E. Brandes:

Right.

That is correct sir.

Now, I have — there are several — there are two things about this first point that I’d like to repeat and reiterate.

One is, I think the government should come forward and clearly state what it is, what its position with regard to issue discount prior to 1953 since we are here dealing with the year 1952.

And further to explain why, the government did not approach Congress prior to 1954 to amend the statue.

Is the government not now in the position where it is coming to this Court and presenting to the Court arguments and reasons that should have been more properly presented to the Congress and which were not presented to the Congress until 1954.

The second point that’s involved in this case is a matter of fundamental importance and the administration of the tax laws.

It involves the question of the extent to which taxpayers are privileged to rely on public pronouncements of the Internal Revenue Service and are privileged to believe that if those pronouncements are changed or if the position set forth therein is changed, they will be changed on the basis that does not discriminate as between taxpayers or as among the taxpayers.

The partnership here purchased the securities at a time when it fully believed, because of the preexisting government practice that had been announced in more than one place and particularly announced in the acquiescence in the Fulton’s case, that issue of discount when realized would bring about capital gain.

The government withdrew the Caulkins acquiescence in 1955.

At the time when the Caulkins acquiescence was withdrawn, the government stated that it could not and there was no basis to distinguish the discount element present in any security from the discount element present in any other security.

In addition, although the Caulkins acquiescence which was a — well, let me say this about acquiescence, that all of the things that the treasury may say “the most significant on this side of the table is the acquiescence.”

This is what the practitioner and the businessman go high.

When the Caulkins acquiescence was withdrawn, the government withdrew it not only retroactively without warning, but withdrew it on a basis that discriminated.

Justice Bernnan:

You distinguish that – you don’t ask us to overrule Automobile Michigan [Inaudible]

Bernard E. Brandes:

No sir.

I ask you to follow Automobile Club of Michigan.

In that case if you will remember sir, the Automobile Clubs’ exempt status was revoked in 1945 and carried back to 1943.

The Automobile Club said that the Commissioner should not be permitted retroactively to change his position.

This Court held that the Commissioner is privileged to change his position to correct the mistake of law, but whether he has acted properly always depends on the circumstances of the case.

And in the discussion of the circumstances of the case, if my memory serves me correctly, there are two aspects that are emphasized.

One is that the carry back to 1943 gave the Automobile Club no cause for complaint, because in 1943 it had already been placed on notice by a publicly issued general counsel’s memorandum that clubs such as it would no longer be exempt from tax.

And most importantly, when the Internal Revenue Service changed its position, it was uniformly applied clear across the boards to every taxpayer similarly situated.

Bernard E. Brandes:

In this case, we have a retroactive application without warning and we have a discriminatory application, because the withdrawal of the Caulkins acquiescence is not applied as against particular taxpayers who purchased a particular kind of security.

Even though at the same time, the Internal Revenue Service admitted that there was no basis on which to distinguish one discount security from any other discount security.

If I may sir, I should like to save the remaining time.

Earl Warren:

You may — you may Mr. Brandes.

Mr. Goodman.

Frank I. Goodman:

Mr. Chief Justice, may it please the Court.

Despite the shortage of time available today, I’d like to begin by restating very briefly the facts of this case.

The partnership of which the petitioners were members, in 1952 purchased $43 million worth of short-term promissory notes, either directly from the obligor corporations or through brokers — through dealers and agents.

These notes bore no stated rate of interest, but in each case, they were issued at discounts ranging from two and three-eights to three and three-quarters percent.

By the end of the tax year, the partnership had sold 20 of these 33 notes for an aggregate gain of $500,000, virtually all of it should be result of discounts at which the notes were originally issued.

The other 13 notes remained on hand unmatured.

The Commissioner determined that the excess of the face amount of the notes over the amount money for which they were purchased represented interest, accruing over the life of each note, both those that were sold and those that were not sold.

And since the partnership was on the accrual basis, the interest accruing on each of the notes was required to be included within the partnership’s taxable income for the year and therefore, in the taxpayers distributed shares.

The taxpayers concede that this treatment would have been entirely appropriate if the notes that had provided for interest in so many words.

But they say, that because the interest element — because the compensation they received for the use of their money was not specifically labeled as such, but was simply added to the amount which the borrower agreed to pay on the maturity of the notes, that they are not required to accrue it and that they are entitled to treat it as capital gain upon the sale of the notes.

Byron R. White:

Everybody agreed that if — that the state [Inaudible] or that it would be —

Frank I. Goodman:

That’s right sir.

And that is true despite the —

Byron R. White:

Of all [Inaudible]

Frank I. Goodman:

Well, the cases holding it to be true dates from about 1954.

Byron R. White:

Yes.

Frank I. Goodman:

Before that time, I think that there was a considerable degree of confusion on this subject. There is no case one way or the other specifically indicating the view prior to 1954.

We think this —

Byron R. White:

This is the acquiescence that you talked about here cover those very interests?

Frank I. Goodman:

Well, of course we don’t know what the Commissioner’s acquiescence covered except a particular case that was before the Court.

That was a non-interest bearing security which was issued at a discount for all practical purposes.

Our contention on that subject is that the case in which the Commissioner acquiesced doesn’t even apply to this case for a somewhat different reason that Mr. Justice White, you talked — you get into those —

Potter Stewart:

That was the retirement not a sale.

Frank I. Goodman:

Essentially that’s right.

Yes Mr. Justice Stewart.

Potter Stewart:

And under that 178 –

Frank I. Goodman:

That’s right.

That’s our position on the Caulkins case.

We think the petitioners that —

Hugo L. Black:

That’s at the Caulkin?

Frank I. Goodman:

Caulkins, that’s the name of it.

We think that the petitioner’s contention is wholly formalistic and that it becomes all the more extraordinary when one further fact is noted which was not adverted to by Mr. Brandes.

The record shows that as each of these notes was purchased, it was immediately pledged as security for a bank loan in an amount exactly equal to the face amount of the note.

Now, that indicates I think fairly clearly that the partnership obtained the $43 million with which to purchase these notes by borrowing it from a bank specifically for the purpose.

In 1952, it paid interest on the money which it borrowed in the amount of $625,000 and claimed that amount as an ordinary deduction on its income tax return.

At the same time, the profit which it realized on the notes which it sold amounted to only $495,000.

So the tax consequences aside the net effect of the borrowing and lending transactions was an economic loss of $130,000.

Now, the explanation for this seeming folly lies of course in the tax consequences.

Assuming that the partners were in the 60% bracket which seems a reasonable assumption, the net effect of their obtaining ordinary interest — ordinary deduction on the interest which they pay while obtaining capital gain on the interest which they received is to reduce their overall tax bill by $250,000, thus not only completely wiping out the economic loss which they incurred before taxes, but giving them a fairly handsome after-tax profit to boot.

And indeed so long as the taxpayers are in the 40% bracket or higher, they stand to gain on this arrangement.

To us, this is merely another illustration of the fact that unless the tax law conforms to the economic realities of a transaction, gimmicks and devices will readily be found to exploit the artificiality and to obtain advantages which the Congress never dreamed of giving.

Our position could be illustrated by a simple analogy, a disarming analogy as Mr. Brandes has referred to it without saying in anyway why it isn’t completely applicable to this case.

If A gives B — A lends B a $100 in return for B’s promise to repay the $100 a year later, plus $6 extra, this obligation can be worded in a number of different ways.

The note could say a $100 plus 6% interest.

It could say a $100 plus 6%, a $100 plus $6 interest, or $100 plus $6 or as in the present case, the note could simply say a $106.

Now, every one of these forms of expression obviously means exactly the same thing and our basic position in this case is that the tax consequences of each of these transactions should be exactly the same whether the interest is specifically labeled as such and whether or not it is stated as a percentage of the amount borrowed or as an amount added to what the borrower agrees to repay on maturity.

In each case, the $6 increment represents exactly the same thing economically and that is compensation paid by the borrower to the lender in exchange for the use of the lender’s money.

In short, interest as this Court has defined it in Deputy versus du Pont.

Now, in the case of the note with the stated interest of 6%, everyone agrees that an accrual basis taxpayer has to accrue the $6 increment ratably over the term of the note.

We say that precisely the same should be true in the case of the non-interest bearing note promising a $106 at maturity.