Cross-appeals from judgment entered in tax refund action after bench trial in the Southern District of New York, Charles H. Tenney, District Judge, 362 F. Supp. 830, awarding taxpayer recovery of federal corporate income taxes and interest for the calendar years 1953 and 1954 in amount of $1,371,397.91 claimed to have been erroneously assessed and collected, the said opinion of Judge Tenney having incorporated findings of fact and conclusions of law set forth in prior opinions by Walter R. Mansfield, then District Judge, 316 F. Supp. 61, and by Inzer B. Wyatt, District Judge, 330 F. Supp. 421.
Kaufman, Chief Judge, Smith and Timbers, Circuit Judges. Smith, Circuit Judge, dissenting.
On these cross-appeals from a judgment entered November 20, 1973 in a tax refund action after a bench trial in the Southern District of New York, Charles H. Tenney, District Judge, 362 F. Supp. 830,*fn1 awarding the taxpayer, Cities Service Company (Cities), recovery of federal corporate income taxes and interest for the calendar years 1953 and 1954 in the amount of $1,371,397.91 claimed to have been erroneously assessed and collected, the essential questions are:
(1) Whether the district court correctly determined that Cities' exchange of its debentures for its outstanding preferred stock resulted in a deductible debt discount.*fn2
(2) Whether the district court correctly determined the appropriate measure of that debt discount.
(3) Whether the district court correctly determined, in computing the deduction to be allowed to Cities for the years 1953 and 1954, that there should be excluded any amortization of debt discount attributable to the pre-1953 years since Cities did not claim such a deduction in its pre-1953 returns.
For the reasons below, we affirm the district court's determinations that the transaction did result in a debt discount which is allowable as a deduction and that there should be excluded any amortization of debt discount attributable to the pre-1953 years; but we reverse and remand for a redetermination of the appropriate measure of the debt discount to be deducted.
I. PRIOR PROCEEDINGS AND CLAIMS OF THE PARTIES
In view of the full exposition of these matters in the opinions of the district court referred to above, it is sufficient for our purpose briefly to summarize only those prior proceedings, claims of the parties and facts necessary to an understanding of our rulings below.
In 1941, Cities Service Company, a Delaware corporation, became a registered holding company under the Public Utility Holding Company Act of 1935, 15 U.S.C. § 79 et seq. (1970). Pursuant to Section 11(e) of the Holding Company Act, 15 U.S.C. § 79k(e),*fn3 Cities was required to simplify its corporate and capital structures. It submitted a plan which in due course was approved by the SEC as amended after hearings as to its fairness. The plan ultimately was enforced by the court. In re Cities Service Co., 71 F. Supp. 1003 (D. Del. 1947).
The amended plan provided for prompt cash redemption of certain outstanding debentures and the issuance of new 30-year 3% sinking fund debentures in exchange for all of Cities' outstanding preferred and preference stock (three classes).*fn4 The aggregate face amount of the new debentures ($115,246,950) was equal to the stated value*fn5 of the preferred and preference stock ($58,690,000), plus the call premiums ($6,885,000), plus dividend arrearages accumulated over 14 years ($49,671,950). Each share of each class of the preferred and preference stock was to receive precisely its call price in face amount of new debentures in the exchange.
By the terms of the indenture under which the debentures were issued, Cities was to retire at least $1,500,000 in principal amount of the debentures annually through a sinking fund. Accordingly, during 1953 it purchased $1,519,500 in face amount of the debentures at a cost of $1,398,357.39; and during 1954 it purchased $1,805,900 in face amount of the debentures at a cost of $1,786,569.02.
Cities paid its taxes for the years 1953 and 1954. It then filed a claim for refund with the District Director, asserting the position summarized below. When no action had been taken with respect to its claim for 1953 after six months and when its claim for 1954 had been disallowed,*fn6 Cities commenced the instant refund action.*fn7
Cities' essential claim is that it received less in value for the debentures than their face amount when they were issued on May 28, 1947 in exchange for its outstanding preferred and preference stock. In short, it says that it issued the debentures at a discount. More specifically, it contends that it received either $45,323,846, the fair market value of the cash and properties originally paid in upon issuance of the preferred stock, or $86,313,600,*fn8 the fair market value of the preferred stock surrendered in the 1947 exchange.
Starting with this premise that the debentures were issued at a discount, Cities urged two alternative theories in the district court in support of its claim for a refund. They were summarized by the district court as follows:
"The first theory holds simply that a deductible loss was realized upon repurchase of debentures at a price higher than the price realized upon their issuance [Int. Rev. Code of 1954, § 165(a)]. The second theory, based on Reg. § 1.61-12 [now Treas. Reg. § 1.163-3(c)(1)(1968)], holds that issuance of the debentures at less than face in 1947 gave rise to bond 'discount' within the meaning of that Regulation, entitling plaintiff to prorate or amortize the discount over the life of the bonds and to deduct both the amortization thereof for the taxable years in question and the unamortized portion of the discount attributable to the debentures retired in those years. Each theory produces two figures for the proposed deduction, depending on which of the two measures of the issue price of the debentures in 1947 is employed [$45,323,846 or $86,313,600]. . . ." 316 F. Supp. at 65 (Mansfield, J.).
The district court summarized the government's position with respect to both theories as follows:
"Defendant's answer to both theories is the same: the debentures were issued at face value. Hence no discount arose from the exchange, and since the consideration received for the debentures equalled their face value, no loss was sustained when plaintiff repurchased them at less than face in 1953 and 1954. Defendant also contends that even if the debentures were issued at less than face, the differential is not deductible discount." Id.
The positions of the parties as summarized above have continued to remain substantially the same.
On the first round in the district court - on cross-motions for summary judgment - Judge Mansfield rejected the government's claim that the transaction was a redemption and concluded that, no matter what value was assigned to the consideration given up by the preferred shareholders and received by Cities in the exchange, "there is every indication that it was substantially less than the face amount of the debentures they received." 316 F. Supp. at 69. The court went on to reject the analogous theory that to permit a deduction would allow Cities to convert nondeductible into deductible expenditures by issuing debentures instead of paying cash to extinguish matured obligations, i.e. calling the preferred by issuing bonds instead of paying cash. Id. at 71.
The court further held that the 1947 exchange effected a real alteration in Cities' liabilities since the obligation to pay dividends on the preferred which depended upon earnings and management's good faith exercise of its discretion to declare dividends was converted into an unconditional commitment to pay the face amount of the new debentures plus 3% annual interest. It held that Cities was entitled to a deduction, but upon which of the two theories urged by Cities the court did not specify. Id. at 71-72.
Finally, the court concluded that the sole material fact actually controverted was the value to Cities of the preferred and preference shares received by it in the exchange. As to this, it stated that the minimum was the value of the original consideration received when the shares were issued, $45,323,846; but that the actual value to Cities could be determined only after consideration of all relevant data, including the market value of the shares, the financial condition of Cities at the time of the exchange, its profits prospects and expert opinion. The court noted that while the market price of the shares would be relevant, it was not conclusive. Accordingly, a trial was ordered solely on the issue of the value to Cities of the preferred and preference stock at the time of the exchange. Id. at 72-74.
On the second round in the district court - on the government's second motion for summary judgment - Judge Wyatt reaffirmed Judge Mansfield's determination and denied the motion. 330 F. Supp. 421.
The third round in the district court was a bench trial before Judge Tenney on the issue previously ordered by Judge Mansfield to be tried. On the issue, Cities claimed the value it received on the exchange was the original consideration paid in for the preferred, $45,323,846; the government claimed that the value was the aggregate face amount of the debentures, $115,246,950. Judge Tenney held that the value to Cities of the preferred and preference stock received on the exchange was its fair market value, $86,313,600.*fn9 362 F. Supp. at 838. Judgment was entered for Cities based on the discount theory.*fn10
Both sides have appealed. The time for filing briefs was extended to await the Supreme Court's decision in Commissioner v. National Alfalfa Dehydrating & Milling Co., 417 U.S. 134, 40 L. Ed. 2d 717, 94 S. Ct. 2129 (1974), 42 U.S.L.W. 4798 (U.S. May 28, 1974).
On this appeal, the government argues that National Alfalfa holds that there can be no deductible bond discount when a corporate taxpayer issues debentures for its outstanding preferred stock. Cities argues that the Court's decision does not preclude such a deduction; that the amount it received for the debentures was the amount originally paid in for the preferred, $45,323,846, or, in the alternative, the fair market value of the ...