Commissioner v. National Alfalfa Dehydrating & Milling Co.

constitute a recapitalization and, therefore, a reorganization, within the meaning of section 368 (a) (1) (E), of the Internal Revenue Code of 1954,” 26 U. S. C. § 368 (a) (1)(E), and that, as a result thereof, under § 354 (a) of the Code, 26 U. S. C. § 354 (a), no gain or loss would be recognized on that exchange by NAD or by its common shareholders. App. 20. The ruling went on to state, “Assuming but not determining that the 5% debenture bonds to be issued qualify as securities (create a genuine relationship of debtor and creditor), gain or loss will be recognized to the preferred stockholders [under § 302 (a) of the Code, 26 U. S. C. § 302 (a)] from the exchange” of the preferred and the dividend arrear-age for the debentures and warrants. The gain or loss so to be recognized would be “measured by the difference between the cost or other adjusted basis of the preferred stock surrendered and the fair market values of the debentures and warrants received.” App. 20-21.

Shareholder approval of the plan proposed by the board was forthcoming in due course. Accordingly, NAD’s articles were amended; on July 23, 1957, the holder of each share of preferred received, in exchange therefor, a $50 face value 5% debenture due July 1, 1975, and a warrant to subscribe to a half share of common at $10 per share in lieu of the dividend arrearage; and the preferred was eliminated and canceled as of August 1. This was reflected on NAD’s books by a debit to the preferred stock account for $2,352,950, thereby eliminating that account, and by a credit to the liability account for the 18-year 5% debentures in the aggregate amount of $2,352,950.

NAD’s preferred shares were not listed. During the period from July 15-30, 1957, the bid quotation for the preferred on the over-the-counter market ranged from a low of 29 to a high of 33, and the offering quotation

Upon audit of NAD’s return for fiscal 1967, the Commissioner of Internal Revenue disallowed the debt discount of $109,804 claimed for that year and $321,657 in loss carryovers from prior taxable years that were due to debt-discount deductions asserted in those years. This resulted in a substantial deficiency in NAD’s 1967 corporate income tax.

On petition for redetermination, the Tax Court, by a unanimous reviewed opinion, upheld the Commissioner. 57 T. C. 46 (1971). Adopting the reasoning of the Court of Claims in Erie Lackawanna R. Co. v. United States, 190 Ct. Cl. 682 , 422 F. 2d 425 (1970), and in Missouri Pacific R. Co. v. United States, 192 Ct. Cl. 318 , 427 F. 2d 727 , modified on rehearing, 193 Ct. Cl. 257 , 433 F. 2d 1324 (1970), cert. denied, 402 U. S. 944 (1971), the Tax Court held that when a corporation issues obligations in exchange for its outstanding preferred, no discount arises if the amount that had been received upon the issuance of the preferred was .equal to

the face amount of the obligations issued upon the exchange. The market value of the preferred at the time of the exchange, therefore, would be of no relevance.

On appeal, the United States Court of Appeals for the Tenth Circuit, by a divided vote, reversed. 472 F. 2d 796 (1973). Relying upon American Smelting & Refining Co. v. United States, 130 F. 2d 883 (CA3 1942), and Atchison, T. & S. F. R. Co. v. United States, 443 F. 2d 147 (CA10 1971), the court held that the difference between the value of the preferred and the face amount of the debentures at the time of the exchange represented a discount or expense of borrowing, and qualified as an interest deduction to be properly amortized over the life of the debentures. We granted certiorari to resolve the indicated conflict. 414 U. S. 817 (1973).

The situation with which we are here concerned, therefore, is one where a taxpayer corporation issued debt obligations, namely, debentures, in exchange for its own outstanding preferred shares. It is not one where the taxpayer issued debt obligations in exchange for cash in an amount less than the obligations’ face amount, or in exchange for property other than its own stock.

Section 163 (a), which is set forth in n. 1, supra, is the statute NAD seeks to invoke in order to have the benefit of a deduction for what it claims is amortizable debt discount. The statute relates simply to “all interest paid or accrued within the taxable year on indebtedness.” NAD’s debentures obviously represented debt, and the stated 5% interest due semiannually on those debentures just as obviously would qualify as a deduction from gross income for NAD under § 163 (a). The issue here, however, is whether NAD is also entitled, in addition to the deduction for the stated interest, to a further deduction,

While it is thus established that debt discount may ensue when a corporate debt obligation is issued at a discount for cash, this Court has never decided the question whether discount may result when debt obligations are issued in exchange for property other than cash. Those courts that have passed upon the issue have reached opposing conclusions. Compare Nassau Lens Co. v. Commissioner, 308 F. 2d 39 (CA2 1962); American Smelting & Refining Co. v. United States, 130 F. 2d 883 (CA3 1942); Southern Fertilizer & Chemical Co. v. Edwards, 167 F. Supp. 879 (MD Ga. 1955), to the effect that debt discount is available, with Southern Natural Gas Co. v. United States, 188 Ct. Cl. 302 , 412 F. 2d 1222 ,

outstanding preferred. It, and the Court of Appeals’ majority, would look to what it calls the “economic realities” of the transaction in order to determine whether a cost of borrowing was incurred. The Court of Appeals likened the transaction to one where the corporation actually issued its $50 debenture for $33 in cash upon the open market (or to a holder of preferred) and then used that cash to purchase and retire outstanding preferred at $33 per share. 472 F. 2d, at 802 . Upon such a transaction, it is claimed, there can be no question whatsoever that a deductible discount of $17 per debenture would result. It is argued that to deny similar treatment to the transaction which did take place, where a direct exchange was made with the preferred shareholder, would require a corporate taxpayer in the future to engage in a complex and expensive series of securities transactions in order to establish its entitlement to a deduction.

This argument, however, calls upon this Court to take two steps that we are reluctant and unwilling to take. First, it 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. Second, it would require us to speculate about the market price and value to the corporation of the debentures in question had they been sold upon the open market.

Even if we were to assume, arguendo, that the hypothetical transaction posed by the taxpayer and the Court of Appeals was indistinguishable, as a matter of economic reality, from what actually occurred, we would not be required, for that reason alone, to recognize a claimed deduction for debt discount. The propriety of a deduction does not turn upon general equitable considerations, such as a demonstration of effective economic and practi

cal equivalence. Rather, it “depends upon legislative grace; and only as there is clear provision therefor can any particular deduction be allowed.” New Colonial Ice Co. v. Helvering, 292 U. S. 435 , 440 (1934); Deputy v. Du Pont, 308 U. S. 488 , 493 (1940). This Court has observed repeatedly that, while a taxpayer is free to organize his affairs as he chooses, nevertheless, once having done so, he must accept the tax consequences of his choice, whether contemplated or not, Higgins v. Smith, 308 U. S. 473 , 477 (1940); Old Mission Portland Cement Co. v. Helvering, 293 U. S. 289 , 293 (1934); Gregory v. Helvering, 293 U. S. 465 , 469 (1935), and may not enjoy the benefit of some other route he might have chosen to follow but did not. “To make the taxability of the transaction depend upon the determination whether there existed an alternative form which the statute did not tax would create burden and uncertainty.” Founders General Corp. v. Hoey, 300 U. S. 268 , 275 (1937); Television Industries, Inc. v. Commissioner, 284 F. 2d 322 , 325 (CA2 1960); Interlochen Co. v. Commissioner, 232 F. 2d 873 , 877 (CA4 1956). See Gray v. Powell, 314 U. S. 402 , 414 (1941).

Both the rationale and the wisdom of the Court’s attitude toward such attempts at reconstruction of transactions are particularly well demonstrated in the present case. In the absence of any actual or even attempted sales of debentures or purchases of the preferred by NAD in the open market, the Court is called upon to speculate as to what the market price and the investor reaction to such events would have been. There are several reasons why we cannot do this:

First, there is nothing in the record establishing the cash price at which the debentures could have been sold upon the market had they been offered for sale. The current rate for money and the credit status of the bor

rower are pertinent factors in the determination of discount (or premium) on an open market, as contrasted with a closed transaction.

Second, there is also nothing in the record to indicate that NAD would have been able to purchase all its outstanding preferred on the open market, or at what price that quantity of stock would have been purchased in light of the impending exchange. See Gulf, M. & O. R. Co. v. United States, 339 F. Supp. 489 (SD Ala.), final decision 31 A. F. T. R. 2d 73 -436 (1972), pending on appeal to CA5 and deferred awaiting the decision in this case; Cities Service Co. v. United States, 316 F. Supp. 61 (SDNY 1970) and 362 F. Supp. 830 (SDNY 1973), appeal to CA2 pending. The stipulated over-the-counter quotations, set forth in n. 4, supra, and in the cited National Stock Summary, are quotations only for what at most was a thin market, and were hardly representative of the fair market value of the entire 47,059 preferred shares outstanding. The preferred’s redemption price at the time was $51 plus the arrearage, or a total of $61, almost double the claimed $33 per share.

Third, when a corporation issues to its preferred shareholders its own new debt obligations in exchange for outstanding preferred, the claimed fair market value of both securities is somewhat artificial since the exchange is effectively insulated from market forces by the intra-corporate and private nature of the transaction. See Missouri Pacific R. Co. v. United States, 192 Ct. Cl., at 324-325, 427 F. 2d, at 730-731 . The economics underlying discount is that it is an adjustment of the difference between the interest prescribed in the instrument issued and the prevailing market rate for money, and it arises because the prescribed rate is too low to sell the obligations at par in that market. See San Joaquin Light & Power Corp. v. McLaughlin, 65 F. 2d 677 , 679 (CA9

1933). Thus, implicit in the concept of debt discount is the assumption, and indeed the requirement, that the transaction be subject to the exigencies of the competitive money market.

Here, there has been no demonstration that the difference between the claimed $33 per share value of NAD's preferred (laying aside for the moment the aforementioned difficulties in arriving at that determination) and the face amount of the debentures is attributable to debt discount. As the Tax Court noted, 57 T. C., at 52 n. 6, there is no evidence of what the fair market value of the bonds was at the time of their issuance. Other factors that would have to be considered would include NAD’s financial condition at the time of the exchange, including both its credit position and its profits prospects, and the availability and cost of capital in the general market as well as from its preferred shareholders. Normally, the market itself performs this evaluative process. Aside from the fact that the transaction was insulated from the market processes, there has been no attempt here to show that the discount rate was determined with a view toward accounting for these several factors rather than simply having been predicated on the par value of the preferred. Accordingly, the requisite evaluation of the property to be exchanged cannot occur in this intracorporate transaction and debt discount cannot be determined. Cf. Gulf, M. & O. R. Co. v. United States, supra; Southern Fertilizer & Chemical Co. v. Edwards, 167 F. Supp., at 881 .

I

t has not been demonstrated that NAD, by the exchange, incurred any additional cost for the use of capital. NAD merely replaced that portion of its paid-in capital represented by its preferred with paid-in capital represented by its debentures. From the perspective of the

the debentures worked equal diminutions in the earnings otherwise available for the common shareholders. The debentures, of course, were to mature in 1975, but the sinking fund provisions for both the preferred and the debentures were comparable. Thus, the interest of the preferred shareholders “was fairly reflected in the highly equivalent characteristics of the debentures into which the preferred was converted.” Penfield v. Davis, 105 F. Supp. 292 , 311 (ND Ala. 1952), aff’d, 205 F. 2d 798 (CA5 1953). 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 NAD 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.

In sum, the alteration in the form of the retained capital did not give rise to any cost of borrowing to NAD. The fact that the preferred may have been worth something in the neighborhood of only $33 per share on the market at the time of the exchange was of no consequence, since NAD was not required to go into that market and purchase those shares. It was able, instead, to obtain the preferred merely by canceling the $50 obligation per share on its equity account and transferring that amount to its debt account. It is in this sense that an exchange of a corporation’s own outstanding preferred for newly issued debt obligations may differ, in the tax sense, from an exchange for other property. Such other property — for example, inventory or the stock

of another corporation — does not equate with a previous contribution of capital which can continue to be utilized by the corporation at no cost upon cancellation of the preferred equity account.

We hold, accordingly, that NAD did not incur amortizable bond discount upon the issuance of its $50 face value 5% debentures in exchange for its outstanding $50 par cumulative preferred stock. The judgment of the Court of Appeals is reversed.

It is so ordered.

Mr. Justice Stewart concurs in the judgment and in Parts I, II, and III of the Court’s opinion.