text:
    F. D. RICH CO., INC., et al. v. UNITED STATES for the use of INDUSTRIAL LUMBER CO., INC.
    No. 72-1382.
    Argued January 9, 1974
    Decided May 28, 1974

      Marshall, J., delivered the opinion of the Court, in which Burger, C. J., and BrenNan, Stewart, White, BlacemuN, Powell, and Rehnquist, JJ., joined. Douglas, J., filed an opinion dissenting in part, post, p. 131.

      Lawrence Gochberg argued the cause for petitioners. With him on the brief were Otto Rohwer and Ronald N. Paul.

      Dennis S. Harlowe argued the cause for respondent. With him on the brief was E. M. Murray.

   Mr. Justice Marshall

delivered the opinion of the Court.

The Miller Act, 49 Stat. 793, as amended, 80 Stat. 1139, 40 U. S. C. § 270a et seq., requires a Government contractor to post a surety bond “for the protection of all persons supplying labor and material in the prosecution of the work provided for” in the contract. The Act further provides that any person who has so furnished labor or material and who has not been paid in full within 90 days after the last labor was performed or material supplied may bring suit on the payment bond for the unpaid balance. 40 U. S. C. § 270b (a). This case presents several unresolved issues of importance in the administration of the Act.

I

Between 1961 and 1968, petitioner F. D. Rich Co. was the prime contractor on numerous federal housing projects. During the years 1963-1966, much if not all of the plywood and millwork for these projects was supplied by Cerpac Co. The Cerpac organization was closely intertwined with Rich. The principals of Rich held a substantial voting interest in Cerpac stock, supplied a major share of its working capital, and were thoroughly familiar with its operations and financial condition.

On October 18, 1965, Rich contracted with the United States to build 337 family housing units at Beale Air Force Base, California. Rich’s Miller Act surety, petitioner Transamerica Insurance Co., posted the payment bond required by the Act. Rich then awarded Cerpac two contracts on the project, one to select, modify, detail, and install all custom millwork, and one merely to supply all standard exterior plywood, each contract incorporating by reference terms of the prime contract. A similar arrangement was employed by Rich and Cerpac on other projects during this period.

On February 22, 1966, Cerpac placed a single order with respondent Industrial Lumber Co. for all exterior plywood required under its plywood contract for the Beale project. Industrial is a broker, purchasing wood products and materials for resale. It acknowledged the complete Cerpac order, purchased the plywood from its own suppliers and arranged for deliveries at the Beale site to begin on March 10, 1966. Each shipment was receipted as it arrived on the site by a Rich representative.

Shortly after Industrial’s shipments began, Rich informed Cerpac that more plywood was needed for another Government project being constructed in Charleston, South Carolina, for which Cerpac had also contracted to supply Rich with all exterior plywood. Rich and Cer-pac decided to divert some of the Beale lumber to Charleston. Accordingly, Industrial was advised to supply, a shipment of the plywood called for under its Beale contract with Cerpac to the South Carolina site. Industrial arranged for the wood to be shipped by one of its suppliers to a railhead near Charleston. The shipment diverted to South Carolina was one of 22 called for by Industrial’s Beale Contract. There were several subsequent shipments to the California site under that contract.

During April and May 1966, Cerpac fell behind in its payments to Industrial, and on July 13, 1966, having not received payment on invoices for nine separate shipments, Industrial gave notice to Rich and its surety of a Miller Act claim and thereafter brought the instant action in the Federal District Court for the Eastern District of California. The District Court recognized that under our decision in MacEvoy Co. v. United States ex rel. Tomkins Co., 322 U. S. 102 (1944), Rich’s liability turned on whether Cerpac was a “subcontractor” within the meaning of the Act or merely a materialman. The District Court found that Cerpac was a subcontractor; hence Industrial, as its supplier, could assert a Miller Act claim against Rich, the prime contractor on the project. The District Court also rejected Rich’s claim that venue for suit on the South Carolina shipment was improper in the Eastern District of California. Accordingly, the District Court granted judgment for Industrial, holding Cerpac and Rich as primary obligees and Transamerica on its bond, jointly and severally liable for the amount of all nine unpaid invoices, $31,402.97, including the amount due on the shipment diverted to South Carolina. The District Court, however, denied Industrial’s claim for attorneys’ fees.

Both Rich and Industrial appealed. The Court of Appeals affirmed the judgment against Rich in large part. On Industrial’s cross-appeal, the court reversed, holding that attorneys’ fees should have been awarded to Industrial as a successful plaintiff under the Miller Act, and remanded to the District Court for consideration of the amount of attorneys’ fees to be awarded. 473 F. 2d 720 (CA9 1973). We granted certiorari. 414 U. S. 816 (1973). We affirm the judgment below to the extent it holds that Cerpac was a “subcontractor” for Miller Act purposes and that there was proper venue, but reverse as to the propriety of an award of attorneys’ fees.

II

Section 270a (a) (2) of the Miller Act establishes the general requirement of a payment bond to protect those who supply labor or materials to a contractor on a federal project. Ordinarily, a supplier of labor or materials on a private construction project can secure a mechanic’s lien against the improved property under state law. But a lien cannot attach to Government property, see Illinois Surety Co. v. John Davis Co., 244 U. S. 376, 380 (1917), so suppliers on Government projects are deprived of their usual security interest. The Miller Act was intended to provide an alternative remedy to protect the rights of these suppliers.

The rights afforded by the Act are limited, however, by the proviso of § 270b (a). In MacEvoy Co. v. United States ex rel. Tomkins Co., supra, this Court construed § 270b (a) to limit the protection of a Miller Act bond to those who had a contractual agreement with the prime contractor or with a “subcontractor.” Those in more remote relationships, including persons supplying labor or material to a mere materialman, were found not to be protected. 322 U. S., at 109-111. Industrial was a supplier of materials to Cerpac. Thus, if Cerpac were a subcontractor for purposes of the Act, Industrial, having given the required statutory notice, could assert a Miller Act claim against Rich, the prime contractor. But, if Cerpac were merely a materialman, Industrial could not assert its Miller Act claim since it would be merely a supplier of materials to a materialman, a relationship found too remote in MacEvoy to enjoy the protections of the Act.

Petitioners assert that the courts below erred in finding Cerpac a subcontractor. Cerpac’s role under the plywood contract alone was that of a broker receiving standard lumber supplied by Industrial and, in turn, supplying it without modification to Rich. Petitioners argue that the court should not have looked beyond the plywood contract to determine Cerpac’s status under the Act.

In MacEvoy, supra, the Court adopted a functional rather than a technical definition for the term subcontractor, as used in the proviso. The Court noted that a subcontractor is “one who performs for and takes from the prime contractor a specific part of the labor or material requirements of the original contract . . . 322 U. S., at 109. The Court went on to explain the reason for the exclusion from the protections of the Act of suppliers of mere materialmen as opposed to those who su]D-ply subcontractors:

“The relatively few subcontractors who perform part of the original contract represent in a sense the prime contractor and are well known to him. It is easy for the prime contractor to secure himself against loss by requiring the subcontractors to give security by bond, or otherwise, for the payment of those who contract directly with the subcontractors. . . . But this method of protection is generally inadequate to cope with remote and undeterminable liabilities incurred by an ordinary materialman, who may be a manufacturer, a wholesaler or-a retailer.” Id., at ,110. (Emphasis added.)

The Court of Appeals properly construed our holding in MacEvoy to establish as a test for whether one is a subcontractor, the substantiality and importance of his relationship with the prime contractor. It is the sub-stantiality of the relationship which will usually determine whether the prime contractor can protect himself, since he can easily require bond security or other protection from those few “subcontractors” with whom he has a substantial relationship in the performance of the contract.

Measured against that test, Cerpac was clearly a subcontractor for the purposes of the Act. The Miller Act is “highly remedial [and] entitled to a liberal construction and application in order properly to effectuate the Congressional intent to protect those whose labor and materials go into public projects.” MacEvoy, supra, at 107. It is consistent with that intent to look at the total relationship between Cerpac and Rich, not just the contract to supply exterior plywood, to determine whether Cerpac was a subcontractor. Cerpac had not only agreed to supply standard plywood but also had a separate contract to select, modify, detail, and install all custom mill-work for the Beale project. Cerpac, in effect, took over a substantial part of the prime contract itself. Moreover, the management and financial structures of the two companies were closely interrelated and their relationship on the Beale project was the same as on many other similar Government projects during the same period. Cerpac was, as the Court of Appeals observed, “in a special, integral, almost symbiotic relationship [with] Rich.” 473 F. 2d, at 724. It would have been easy for Rich to secure itself from loss as a result of a default by Cerpac.

Ill

We also agree with the courts below that venue under the Miller Act for suit on the shipment diverted to South Carolina properly lay in the Eastern District of California. The Act provides:

“Every suit instituted under this section shall be brought in . . . the United States District Court for any district in which the contract was to be performed and executed and not elsewhere . . . .” 40 U.S.C. §270b (b).

Petitioners argue that this provision bars a district court in California from adjudicating respondent’s claims arising from the shipments of plywood delivered in South Carolina. But § 270b (b) is merely a venue requirement and there was clearly a sufficient nexus for its satisfaction. The “Beale 647” contract between Cerpac and Industrial was executed in California, all of the materials described therein to be delivered to a worksite in that State. Although one of the 22 shipments made pursuant to the contract was later diverted to South Carolina for petitioner Rich’s convenience, the site for performance of the original contract remained the same for Miller Act purposes. Several shipments to the Beale site were made after the South Carolina shipment. Moreover, petitioners have pointed to no prejudice resulting from the case’s being heard in the California court and considerations of judicial economy and convenience clearly support venue in the District Court where all of respondent’s claims arising from the “Beale 647” contract could be adjudicated in a single proceeding.

IV

We turn now to the question of whether attorneys’ fees were properly awarded respondent as a successful Miller Act plaintiff. The so-called “American Rule” governing the award of attorneys’ fees in litigation in the federal courts is that attorneys’ fees “are not ordinarily recoverable in the absence of a statute or enforceable contract providing therefor.” Fleischmann Distilling Corp. v. Maier Brewing Co., 386 U. S. 714, 717 (1967). There was no contractual provision concerning attorneys’ fees in this case. Nor does the Miller Act explicitly provide for an award of attorneys’ fees to a successful plaintiff. But the Court of Appeals construed the Act to require an award of attorneys’ fees where the “public policy” of the State in which suit was brought allows for the award of fees in similar contexts. The court reasoned that the Act provides remedies “ ‘in lieu of the lien upon land and buildings customary where property is owned by private persons’ .... The federal remedy was intended to substitute for the unavailable state remedy of the lien. Therefore, if state [law] allows a supplier on private projects to recover such fees, there is no reason for a different rule to apply to federal projects . . . .” Looking to California law, the Court of Appeals found an award of attorneys’ fees proper because Cal. Govt. Code § 4207 (1966) allowed for the recovery of attorneys' fees in state actions on the bonds of contractors for state and municipal public works projects.

We think the Court of Appeals erred in its construction of the statute. The Miller Act provides a federal cause of action, and the scope of the remedy as well as the substance of the rights created thereby is a matter of federal not state law. Neither respondent nor the court below offers any evidence of congressional intent to incorporate state law to govern such an important element of Miller Act litigation as liability for attorneys’ fees. Many federal contracts involve construction in more than one State, and often, as here, the parties to Miller Act litigation have little or no contact, other than the contract itself, with the State in which the federal project is located. The reasonable expectations of such potential litigants are better served by a rule of uniform national application.

A uniform rule also avoids many of the pitfalls which have already manifested themselves in using state law referents. For example, California law does not provide for awards of attorneys’ fees in suits arising from private construction projects. And, a California court had held that the state statute providing for awards of attorneys’ fees in suits on the bonds of state and municipal.public works contractors is inapplicable to construction projects of the United States. The Court of Appeals nonetheless held that since federal law controls Miller Act recoveries, it was free to look to “state policy” rather than state law and proceeded to find an award of attorneys' fees appropriate. Although the court below premised its decision on the theory that a Miller Act remedy is afforded “ 'in lieu of the lien upon land and buildings customary where property is owned by private persons,’ ” it gave respondent more protection than California law affords litigants involved in disputes arising from private construction projects who are not entitled to an award of attorneys’ fees. We think it better to extricate the federal courts from the morass of trying to divine a “state policy” as to the award of attorneys’ fees in suits on construction bonds.

Finally, the Court of Appeals intimates that in providing that Miller Act claimants should recover the “sums justly due,” 40 TJ. S. C. § 270b (a), Congress must have intended to provide for the award of attorneys’ fees because without such fee shifting, Miller Act claimants would not be fully compensated — the claimant’s recovery would always be diminished by the cost of his legal representation. This argument merely restates one of the oft-repeated criticisms of the American Rule. Almost a half century ago, the Massachusetts Judicial Council pleaded for reform, asking, “On what principle of justice can a plaintiff wrongfully run down on a public highway recover his doctor’s bill but not his lawyer’s bill?” We recognize that there is some force to the argument that a party who must bear the costs of his attorneys’ fees out of his recovery is not made whole. But there are countervailing considerations as well. We have observed that “one should not be penalized for merely defending or prosecuting a lawsuit, and that the poor might be unjustly discouraged from instituting actions to vindicate their rights if the penalty for losing included the fees of their opponents’ counsel.” Fleischmann Distilling Corp. v. Maier Brewing Co., 386 U. S. 714, 718 (1967). Moreover, “the time, expense, and difficulties of proof inherent in litigating the question of what constitutes reasonable attorney’s fees,” ibid., has given us pause, even though courts have regularly engaged in that endeavor in the many contexts where fee shifting is mandated by statute, policy, or contract. Finally, there is the possibility of a threat being posed to the principle of independent advocacy by having the earnings of the attorney flow from the pen of the judge before whom he argues.

The American Rule has not served, however, as an absolute bar to the shifting of attorneys’ fees even in the absence of statute or contract. The federal judiciary has recognized several exceptions to the general principle that each party should bear the costs of its own legal representation. We have long recognized that attorneys’ fees may be awarded to a successful party when his opponent has acted in bad faith, vexatiously, wantonly, or for oppressive reasons, or where a successful litigant has conferred a substantial benefit on a class of persons and the court’s shifting of fees operates to spread the cost proportionately among the members of the benefited class. The lower courts have also applied a rationale for fee shifting based on the premise that the expense of litigation may often be a formidable if not insurmountable obstacle to the private litigation necessary to enforce important public policies. This “private attorney general” rationale has not been squarely before this Court and it is not so now; nor do we intend to imply any view either on the validity or scope of that doctrine. It is sufficient for our purposes here to observe that this case clearly does not fall within any of these exceptions.

Miller Act suits are plain and simple commercial litigation. In effect then, we are being asked to go the last mile in this case, to judicially obviate the American Rule in the context of everyday commercial litigation, where the policies which underlie the limited judicially created departures from the rule are inapplicable. This we are unprepared to do. The perspectives of the profession, the consumers of legal services, and other interested groups should be weighed in any decision to substantially undercut the application of the American Rule in such litigation. Congress is aware of the issue. Thus whatever the merit of arguments for a further departure from the American Rule in Miller Act commercial litigation, those arguments are properly addressed to Congress.

The judgment of the Court of Appeals is affirmed insofar as it holds that Cerpac is a subcontractor for Miller Act purposes and that there was proper venue for suit on the shipment diverted to South Carolina, but reversed insofar as it holds that an award of attorneys’ fees to respondent Industrial is required by the Act.

It is so ordered.

Mr. Justice Douglas,

dissenting in part.

The Court, dealing with the Miller Act’s predecessor, held in Illinois Surety Co. v. John Davis Co., 244 U. S. 376, 380, that the Heard Act “must be construed liberally.” That same principle applies to the Miller Act. Fleisher Co. v. United States ex rel. Hallenbeck, 311 U. S. 15, 17-18. The Act is silent as to attorneys’ fees, saying only that the payment bond shall allow the supplier “to prosecute said action to final execution and judgment for the sum or sums justly due him.” 40 U. S. C. § 270b (a).

The Miller Act is unlike the Lanham Act involved in Fleischmann Distilling Corp. v. Maier Brewing Co., 386 U. S. 714. That Act itemized the components of the remedy which the Act afforded: injunctive relief, treble damages, and “costs” (which by federal statute did not include attorneys’fees). Id., at 719-720. Moreover, attempts to amend the Lanham Act to include attorneys’ fees had never succeeded, id., at 721. Here there is no such legislative history; nor does the Miller Act itemize the components of the “sum or sums justly due.”

The Court says that dependence on state law is inappropriate, for we deal with a federal standard that should be uniform. That takes great liberties with the Miller Act. Here the contract and law were made in California and were to be performed there. In Illinois Surety Co. v. John Davis Co., supra, the contract and law were made in Illinois and were to be performed there. “Questions of liability for interest must therefore be determined by the law of that State,” said Mr. Justice Brandéis speaking for the Court, 244 U. S., at 381. If state law would give the claimant interest, it should give him attorneys’ fees based on the purpose of the Miller Act. Judge Carter writing for the Court of Appeals pointed out that the Miller Act is the federal equivalent of state lien laws. See 473 F. 2d 720, 727. The remedy in a federal suit is therefore properly composed of the same elements as would be available to lien claimants in a state court collecting for labor and materials furnished on nonfederal projects. One of the elements of recovery permitted in a California court is attorneys' fees. The “sum or sums justly due” should as a matter of federal law be construed to be the same as that -due a claimant whose remedy is based on a state statute, when the federal remedy was intended to be the equivalent of the state remedy.

What Mr. Justice Brandéis said of interest is equally applicable to attorneys’ fees under the Miller Act. Under the circumstances present here it would seem quite unjust not to include in the sum that is due the cost of collecting that sum.

       Government contracts of less than $2,000 in value are excepted from the statute’s coverage.

       Shipments under the contract were invoiced by the truckload. The South Carolina shipment involved two such truckloads, while the other 21 shipments were each of only one truckload of lumber.

       When Cerpac fell behind in its payments, Industrial indicated it would not deliver the final two truckloads of wood to the Beale project until it received satisfactory assurances of payment. Rich agreed to pay Industrial directly for the last two shipments, with Cerpac to receive its customary profit as a commission from Industrial. The last two shipments were made on May 18 and June 23, 1966, invoices being payable in full 30 days thereafter. The shipments were invoiced directly to Rich with copies to Cerpac, the invoices showing the shipments as being under the original “Beale 647” contract between Industrial and Cerpac. Rich nonetheless refused to pay the full invoice price of the two final shipments. Rich has since conceded its obligation to pay Industrial’s claim for these two shipments, so there is no longer any controversy in regard to the amounts due on those invoices.

       Cerpac subsequently filed for discharge in bankruptcy and is no longer a party.

       All invoices under the Beale contract between Industrial and Cerpac were payable within 30 days with interest at an annual rate of eight percent after the due date. The District Court awarded Industrial seven percent interest on all “unliquidated claims.” The Court of Appeals, however, ruled that the amounts due under the terms of the contract were liquidated damages and should bear an interest rate of eight percent.
      The District Court had also given judgment against Transamerica on its bond for the shipment which was sent to the South Carolina site. The Court of Appeals held that judgment should not have been rendered against Transamerica for material not delivered to the project for which it served as surety.

       Petitioners also raise issues in their brief concerning the timeliness of the Miller Act notice and the amount of prejudgment interest awarded respondent. Those issues were not raised in the petition for certiorari, hence are not properly before the Court. See, e. g., Namet v. United States, 373 U. S. 179, 190 (1963); Rule 23.1 (c) of the Rules of this Court.

       See, e. g., Aetna Casualty & Surety Co. v. United States ex rel. Gibson Steel Co., 382 F. 2d 615, 617 (CA5 1967); Basich Bros. Construction Co. v. United States ex rel. Turner, 159 F. 2d 182 (CA9 1946); cf. United States ex rel. Bryant v. Lembke Construction Co., 370 F. 2d 293 (CA10 1966).

        Travelers Indemnity Co. v. United States ex rel. Western Steel Co., 362 F. 2d 896, 898 (CA9 1966); United States ex rel. Wellman Engineering Co. v. MSI Corp., 350 F. 2d 285, 286 (CA2 1965).

       Beale Air Force Base is located in the jurisdiction of the Federal District Court for the Eastern District of California, hence respondent brought suit on the Beale contract in that court.

         United States ex rel. Capolino Sons, Inc. v. Electronic & Missile Facilities, Inc., 364 F. 2d 705 (CA2 1966); see cases collected, id., at 707.

       The Court of Appeals reversed the judgment against Trans-america, on its bond, as to the shipment of wood diverted to South Carolina, because a Miller Act surety is liable only for material supplied for use on the bonded project. But, a decision on the ultimate question of the surety’s liability involves different considerations from the questions of whether venue for suit on the bond is proper. Petitioner Rich’s liability for the amount due on the South Carolina shipment was based on a pendent claim, the substance of which was not challenged in this Court or in the Court of Appeals.

       473 F. 2d 720, 727 (1973). The same analysis has been accepted in several other cases; see Transamerica Insurance Co. v. Red Top Metal, Inc., 384 F. 2d 752 (CA5 1967); United States ex rel. White Masonry, Inc. v. F. D. Rich Co., 434 F. 2d 855, 859 (CA9 1970); Arnold v. United States ex rel. Bowman Mechanical Contractors, Inc., 470 F. 2d 243, 245 (CA10 1972).

       After the decision in the District Court, but prior to the Court of Appeals’ opinion, Cal. Govt. Code §4207 (1966) was replaced, and the effective provisions transferred to Cal. Civ. Code § 3250 (Supp. 1974), by an act of the California Legislature, dated August 31, 1969, that took effect on January 1, 1971. Given our reasoning, however, the revision in language of the applicable California law is of no relevance to the result reached herein.

        B. C. Richter Contracting Co. v. Continental Casualty Co., 230 Cal. App. 2d 491, 41 Cal. Rptr. 98 (1964) (construing the former law, see n. 13, supra).

       The American Rule has come under repeated criticism over the years. See generally Ehrenzweig, Reimbursement of Counsel Fees and the Great Society, 54 Calif. L. Rev. 792 (1966); Kuenzel, The Attorney’s Fee: Why Not a Cost of Litigation?, 49 Iowa L. Rev. 75 (1963); McLaughlin, The Recovery of Attorney’s Fees: A New Method of Financing Legal Services, 40 Ford. L. Rev. 761 (1972) ; McCormick, Counsel Fees and Other Expenses of Litigation as an Element of Damages, 15 Minn. L. Rev. 619 (1931); Stoebuek, Counsel Fees Included in Costs: A Logical Development, 38 U. Colo. L. Rev. 202 (1966); Note, Attorney’s Fees: Where Shall the Ultimate Burden Lie?, 20 Vand. L. Rev. 1216 (1967).

       Judicial Council of Massachusetts, First Report, 11 Mass. L. Q. 1, 64 (1925).

       See, e. g., Vaughan v. Atkinson, 369 U. S. 527 (1962); McEnteggart v. Cataldo, 451 F. 2d 1109 (CA1 1971); Bell v. School Bd. of Powhatan County, 321 F. 2d 494 (CA4 1963); Rolax v. Atlantic Coast Line R. Co., 186 F. 2d 473 (CA4 1951); 6 J. Moore, Federal Practice ¶ 54.77 [2], p. 1709 (2d ed. 1974).

       See, e. g., Hall v. Cole, 412 U. S. 1 (1973); Mills v. Electric Auto-Lite Co., 396 U. S. 375 (1970); Natural Resources Defense Council v. EPA, 484 F. 2d 1331 (CA1 1973); Callahan v. Wallace, 466 F. 2d 59 (CA5 1972); Bright v. Philadelphia-Baltimore-Washington Stock Exchange, 327 F. Supp. 495, 506 (ED Pa. 1971); cf. Nussbaum, Attorney’s Fees in Public Interest Litigation, 48 N. Y. U. L. Rev. 301 (1973); Comment, The Allocation of Attorney’s Fees After Mills v. Electric Auto-Lite Co., 38 U. Chi. L. Rev. 316 (1971).

       See, e. g., Cooper v. Allen, 467 F. 2d 836 (CA5 1972); Knight v. Auciello, 453 F. 2d 852 (CA1 1972); Lee v. Southern Home Sites Corp., 444 F. 2d 143 (CA5 1971); La Raza Unida v. Volpe, 57 F. R. D. 94 (ND Cal. 1972); Ross v. Goshi, 351 F. Supp. 949 (Haw.1972); Sims v. Amos, 340 F. Supp. 691 (MD Ala.1972); cf. Bradley v. School Bd. of the City of Richmond, 416 U. S. 696 (1974); Northcross v. Memphis Bd. of Education, 412 U. S. 427 (1973); Newman v. Piggie Park Enterprises, Inc., 390 U. S. 400 (1968); Nussbaum, n. 18, supra; Note, Awarding Attorneys’ Fees to the “Private Attorney General”: Judicial Green Light to Private Litigation in the Public Interest, 24 Hastings L. J. 733 (1973).

       A congressional committee charged with making a broad-based inquiry about legal services is currently studying, inter alia, the general issue of attorneys’ fees. Hearings on Legal Fees before the Subcommittee on Representation of Citizen Interests of the Senate Committee on the Judiciary, 93d Cong., 1st Sess. (1973); cf. S. Rep. No. 93-146 (1973), accompanying S. Res. 101.

      The Court of Appeals for the Fifth Circuit awarded attorneys’ fees under a Florida statute where suit was brought under the Miller Act, United States ex rel. Weyerhaeuser Co. v. Bucon Construction Co., 430 F. 2d 420, 425. And see United States ex rel. White Masonry, Inc. v. F. D. Rich Co., 434 F. 2d 855, 859, where the Court of Appeals for the Ninth Circuit followed Alaska law.


source: Caselaw Access Project

author: Mr. Justice Blackmun

license: Public Domain

text:
    COMMISSIONER OF INTERNAL REVENUE v. NATIONAL ALFALFA DEHYDRATING & MILLING CO.
    No. 73-9.
    Argued January 14, 1974
    Decided May 28, 1974

      Blackmun, J., delivered the opinion of the Court, in which Burger, C. J., and Douglas, Brennan, White, Marshall, Powell, and Rehnquist, JJ., joined, and in Parts I, II, and III of which Stewart, J., joined. Stewart, J., concurred in the judgment.

      Stuart A. Smith argued the cause for petitioner. With him on the brief were Solicitor General Bork, Assistant Attorney General Crampton, Meyer Rothwacks, and Ernest J. Brown.

      Charles White Hess argued the cause for respondent. With him on the brief was Ronald B. Stang

      Briefs of amici curiae urging affirmance were filed by Thomas E. Tyre for Cities Service Co.; by Robert T. Molloy, James Ogden, Mark M. Hennelly, Donald E. Engle, George E. Bailey, Robert E.

        Simpson, and James L. Boring for St. Louis San Francisco Railway Co. et al.; by Alan D. Berlin, Walter J. Rockier, and Julius M. Greisman for Norton Simon, Inc.; and by Paul A. Peterson for Fed-Mart Corp.

   Mr. Justice Blackmun

delivered the opinion of the Court.

A corporate taxpayer in 1957 issued $50 face value 5% sinking fund debentures in exchange for its outstanding $50 par 5% cumulative preferred shares. At the time, the preferred apparently had a fair market value of less than $50 per share. This case presents the question whether, under § 163 (a) of the Internal Revenue Code of 1954, 26 U. S. C. § 163 (a), the taxpayer is entitled to an income tax deduction for amortizable debt discount claimed to be the difference between the face amount of the debentures and the preferred's value at the time of the exchange.

I

The facts are stipulated. The respondent, National Alfalfa Dehydrating and Milling Company (hereinafter called “NAD” or the “taxpayer”), is a Delaware corporation organized in May 1946. It has its principal office at Shawnee Mission, Kansas. It is engaged in the business of dehydrating and milling alfalfa.

At its organization, NAD was authorized to issue $50 par cumulative preferred shares and $1 par common shares. The preferred was entitled to preferential dividends at the rate of 5% per annum and was redeemable, in whole or in part, at the discretion of the board of directors or through the operation of a sinking fund, at a stated, variable price which, in 1957, was $51 per share plus accrued dividends. The sinking fund provision required that 20% of net earnings (after the payment of the preferred’s dividends) was to be set aside and employed for the redemption of preferred. Any shares so redeemed were to be retired and could not be reissued. If there was a dividend arrearage, the preferred could not be purchased, redeemed, or otherwise acquired for value by the corporation unless the holders of 50% of the preferred shares consented, or unless NAD notified all preferred shareholders of its desire to purchase and invited tender offers. Upon voluntary liquidation, the preferred was entitled to $50 per share plus accrued dividends before any distribution was made to holders of the common shares.

Prior to July 23, 1957, NAD had outstanding common shares and 47,059 preferred shares on which there were dividend arrearages of $10 per share. The preferred outstanding thus had an aggregate par value of $2,352,950 as of that date.

On April 8, 1957, NAD’s board of directors adopted resolutions “to effectuate a reorganization of the Company by way of recapitalization.” App. 56. The plan proposed by the board had three steps: (1) an amendment of NAD’s articles of incorporation to eliminate the preferred as of August 1, 1957, to increase the par value of the common from $1 to $3 and the number of shares of common authorized from 763,000 to 1,000,000, and to authorize the issue of warrants for the purchase of common shares; (2) the indentured issuance of $2,352,950 principal amount of 18-year 5%- sinking fund debentures due July 1, 1975, with one $50 debenture to be exchanged for each share of outstanding $50 preferred; and (3) the issuance, to the holder of each share of preferred, of a warrant to purchase one-half share of common at $10 per share in lieu of the $10 dividend arrearage. The members of the board would have testified that the “principal business purpose behind the 1957 exchange of debentures for the preferred stock was to enable National Alfalfa to expand its eastern producing areas.” Id., at 25.

After the board had taken this action, NAD and Fidelity-Philadelphia Trust Company, as trustee, executed a trust indenture dated July 1, 1957, pursuant to which the aforementioned debentures were to be issued in exchange for NAD’s outstanding preferred.

Fidelity-Philadelphia Trust Company, on behalf of NAD, requested a ruling from the United States Treasury Department as to the federal income tax consequences of the plan. A responsive letter-ruling over the signature of the Chief, Reorganization and Dividend Branch, was forthcoming on May 29, 1957. The request had sought a ruling that all aspects of the plan would be tax free. The ruling, however, was to the effect that the exchange of the $1 par common for $3 par common “will 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 ranged from a low of 32 to a high of 35. App. 161. On July 23, when the exchange was effected, the midpoint between' the bid and offering quotations on the over-the-counter market was 33. The National Stock Summary for October 1, 1957, showed 100 shares of NAD preferred wanted on July 9 at 32 and on July 10 at 33, and 100 shares offered on July 10 at 35. Id., at 167. It showed no quotations for the warrants in July and only nominal figure want quotations for them on four dates in August. Id., at 168.

On each of its federal income tax returns for the fiscal years ended April 30, 1958, to 1967, inclusive, NAD claimed a deduction under § 163 (a) for what it regarded as interest, by reason of debt discount, measured by the difference between $33 per share for the preferred on July 23, 1957, and the face amount of the debentures. This difference amounted to $800,003 ($2,352,950 for the debentures, less $1,552,947 for the preferred). The $800,003 was then amortized on a straight-line basis over the 18-year life of the debentures, with an addition each year for the unamortized discount on any debentures currently repurchased or redeemed. See Rev. Rul. 70-353, 1970-2 Cum. Bull. 39. The deductions claimed are set forth in the margin; those of the earlier years were reflected in losses carried over to fiscal 1967.

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).

II

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, as “interest paid or accrued,” for an appropriately amortized portion of the claimed $17 difference between the face amount of each $50 debenture and the value of each share of preferred on July 23, 1957.

Original-issue discount typically arises where an issuer sells its debt obligation on the market for cash at a price less than the face amount of the obligation. The difference, obviously, is the discount. A simple example is where a corporation issues its 6% $1,000 10-year bond for $950 cash. The corporation is obliged to pay and the bondholder is entitled to receive, the stated annual interest of 6%, or $60. That amount is deductible by the corporation and is includable in the payee’s gross income as interest received. But the $50 difference between the face amount of the obligation and the issue price is an additional cost to the issuing corporation for the use of the money it is borrowing. That cost spread over the 10-year life of the bond amounts to $5 per year. Accepted accounting practice treats this discount as interest under § 163 (a).

The Internal Revenue Code of 1939 and its predecessors did not provide explicitly for amortization and deduction of debt discount. The successive regulations, however, beginning with Art. 150 of Treasury Regulations 33 (revised 1918), issued under the Revenue Act of 1916, have provided for such amortization and deduction by the issuer.

The first statutory recognition of bond discount appeared in § 1232 (b)(1) of the 1954 Code. That section provides:

“For purposes of subsection (a), the term 'original issue discount’ means the difference between the issue price and the stated redemption price at maturity.. ..”

Section 1232 (b) (2) defines “issue price” in some detail.

This Court has recognized debt discount as an additional cost incurred in borrowing money. In Helvering v. Union Pacific R. Co., 293 U. S. 282 (1934), in considering Art. 150 of Regulations 33 (revised 1918), which described bond discount as a “loss” to be “prorated over the life of the bonds sold,” the Court referred to discount not only as a loss but also as “interest paid for the use of capital procured by a bond issue.” 293 U. S., at 286. More recently, in United States v. Midland-Ross Corp., 381 U. S. 54 (1965), we clarified any ambiguity that may have resulted from the interest-loss approach when we stated, id., at 57:

“Earned original issue discount serves the same function as stated interest.... [I] t is simply ‘compensation for the use or forbearance of money.’ Deputy v. du Pont, 308 U. S. 488, 498.”

It was also observed that,

“despite some expressions indicating a contrary view, this Court has often recognized the economic function of discount as interest.” Id., at 66 (footnote omitted).

Accordingly, the discount may result ultimately in income to the purchaser, but when amortized over the life of the obligation, it is deductible by the issuer.

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, 1235-1239 (1969); Montana Power Co. v. United States, 141 Ct. Cl. 620, 159 F. Supp. 593, cert. denied, 358 U. S. 842 (1958); Montana Power Co. v. United States, 232 F. 2d 541 (CA3) (en banc), cert. denied, 352 U. S. 843 (1956), to the effect that it is not available. This, of course, is a broader question than the one presented in the present case, and we need not, and do not, decide that broader issue. We are concerned, instead, only with the narrow issue whether debt discount arises where a corporate taxpayer issues an obligation in exchange for its own outstanding preferred shares.

In order properly to determine whether debt discount may be said to arise in such a situation, it becomes necessary to recognize the reason or factor that has been thought to justify the deduction. This has been the economic resemblance, in both form and function, which bond discount bears to stated interest for which the Revenue Acts and the Codes have allowed a deduction. Although, as has been noted, there has been some descriptive confusion in the regulations, with their references to "loss” as well as to “interest,” and, as has also been noted, this Court, in Helvering v. Union Pacific R. Co., 293 U. S., at 286, seemed to describe discount both as “interest paid for the use of capital” and as “loss resulting from the funding operation,” the relevant inquiry in each case must be whether the issuer-taxpayer has incurred, as a result of the transaction, some cost or expense of acquiring the use of capital. It is to that inquiry we now turn.

Ill

It is NAD’s position, of course, that amortizable bond discount arose on the exchange of its debentures for its 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 practical 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 borrower 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.

IV

It 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 corporation, the transaction was the exchange of one form of interest or participation in the corporation for another. But the corporate assets were neither increased nor diminished.

To be sure, upon the issuance of its debentures, NAD assumed a fixed obligation to pay at a date certain. The transaction, therefore, perhaps could be said to be something more than a mere reshuffling of the corporation’s capital structure, see Helvering v. Southwest Consolidated Corp., 315 U. S. 194, 202 (1942), since a creditor was substituted for a holder with an ownership interest. But again, when viewed from the corporation’s perspective, and regardless of the income tax effect upon the former preferred shareholder, which we deem to be irrelevant, there has been no new capital acquired and no additional cost incurred in retaining the old capital. See St. Louis-S. F. R. Co. v. United States, 195 Ct. Cl. 343, 350, 444 F. 2d 1102, 1106 (1971), cert. denied, 404 U. S. 1017 (1972).

In obvious explanation of this, NAD originally received $50 cash for each share of preferred. Although it was not obligated to repay that sum at any fixed time, it made use of that cash pursuant to the provisions of its articles, including both the sinking-fund and the redemption-liquidation provisions. Upon the exchange, the corporation canceled the preferred, and thus eliminated the preferred stock account upon its books, together with the preferred’s attendant obligations. The market value of the preferred at that moment bore no direct relationship to the amount of funds on hand. The capital “freed” by the cancellation of the preferred was merely transferred to the liability account for the debentures. No new capital was involved. See Claussen’s, Inc. v. United States, 469 F. 2d 340 (CA5 1972).

It is true that there was some change in the corporate structure. Henceforth, NAD would receive a deduction for interest paid on the debentures, whereas the 5% dividend paid on the preferred had not been deductible. The common shareholders were benefited by the elimination of the dividend arrearages on the preferred and by the elimination of the premium payable on the preferred’s retirement. Yet the change was not great. The fixed interest on the debentures was equal to the cumulative dividend on the preferred, and both the preferred and 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.

      “§T63. Interest.
      “(a) General rule.
      "There shall be allowed as a deduction all interest paid or accrued within the taxable year on indebtedness.”

       The resolutions are set forth in full in the opinion of the Court of Appeals. 472 F. 2d 796, 798 n. 1 (CA10 1973).

       The indenture provided for subordination, redemption, and a sinking fund. Specifically, the debentures were to be subordinate to bank loans for inventory purposes and to obligations for materials, services, and labor supplied in the normal course of business. They were redeemable, in whole or in part, and from time to time, after July 1, 1958, at par plus accrued interest.
      The sinking fund provision required NAD, after April 30, 1959, to set aside annually, for redemption of debentures at par plus accrued interest, the lesser of (a) the sum sufficient to redeem $196,080 face amount of debentures, or (b) the consolidated net earnings for the fiscal year, with the proviso that if the latter became applicable for any year, the fixed figure was to be cumulative.
      NAD has not been in default in the performance of these indenture obligations. As of April 30, 1967, only $581,300 of the original $2,352,950 of debentures remained outstanding. The rest had been redeemed or otherwise repurchased or retired. App. 29.

       Date Bid Offer Date Bid Offer
      July 15 33 35 July 23 32 34
      July 16 32 35 July 24 32 35
      July 17 32 34 July 25 29 32
      July 18 31 34 July 26 30 33
      July 19 32 34 July 29 30 33
      31 33 July 30 30 33

       The deductions for discount taken by NAD on its returns for its fiscal year 1958 through 1967 were:

        Year Ended Unamortized Discount On Bonds Currently Repurchased or Redeemed Straight-line Amortization Total
      4/30/58 $37,037 $37,037
      4/30/59 $20,104 43,273 63,377
      4/30/60 17,007 42,310 59,317
      4/30/61 28,743 28,743
      4/30/62 14,062 27,751 41,813
      4/30/63 27,751 27,751
      4/30/64 26,624 25,562 52,186
      4/30/65 37,903 22,168 60,071
      4/30/66 4,139 21,761 25,900
      4/30/67 98,824 10,980 109,804
      $505,999 App. 28.

       See H. Finney & H. Miller, Principles of Accounting, Intermediate 263 (6th ed. 1965); W. Meigs et al., Intermediate Accounting 683-688 (3d ed. 1974).

       Art. 544 of Regulations 45, promulgated under the Revenue Act of 1918; Art. 545 (3) (a) of Regulations 62, 65, and 69, promulgated, respectively, under the Revenue Acts of 1921, 1924, and 1926; Art. 68 (3) (a) of Regulations 74 and 77, promulgated, respectively, under the Revenue Acts of 1928 and 1932; Art. 22 (a)-

        18 (3) (a) of Regulations 86, 94, and 101, promulgated respectively, under the Revenue Acts of 1934, 1936, and 1938; and §29.22 (a)-17 (3) (a) of Regulations 111, promulgated under the Internal Revenue Code of 1939. See Montana Power Co. v. United States, 232 F. 2d 541, 546-548 (CA3), cert. denied, 352 U. S. 843 (1956).
      Under the 1954 Code, the relevant provision first appeared in the Income Tax Regulations as § 1.61-12 (c) (3) concerning gross income:
      “If bonds are issued by a corporation at a discount, the net amount of such discount is deductible and should be prorated or amortized over the life of the bonds... .”
      Since the issuance of T. D. 6984, 1969-1 Cum. Bull. 38, this same language has appeared under the interest deduction provision in § 1.163-3 (a)(1).

       The 1954 Code’s § 1232 (b) (2) was amended by the Interest Equalization Tax Act, Pub. L. 88-563, § 5, 78 Stat. 845, and by the Tax Reform Act of 1969, Pub. L. 91-172, § 413 (b), 83 Stat. 611, applicable to bonds and other evidences of indebtedness issued after May 27, 1969. As so amended, the statute, in pertinent part reads:
      “In the case of a bond or other evidence of indebtedness [other than a bond or other evidence of indebtedness . . . issued pursuant to a plan of reorganization within the meaning of section 368 (a) (1)], which is issued for property and which—
      “ (A) is part of an issue a portion of which is traded on an established securities market, or
      “(B) is issued for stock or securities which are traded on an established securities market,
      “the issue price of such bond or other evidence of indebtedness . . . shall be the fair market value of such property. Except in cases to which the preceding sentence applies, the issue price of a bond or other evidence of indebtedness . . . which is issued for property (other than money) shall be the stated redemption price at maturity.”
      Inasmuch as NAD’s debentures were issued in 1957, the 1969 amendment is not applicable to the transaction.

       It was unsettled for some time whether income realized by an owner of an original discount obligation was taxable to that owner as ordinary income or as capital gain. In Commissioner v. Caulkins, 144 F. 2d 482 (CA6 1944), decided under the 1939 Code, it was held that gain upon surrender of ah installment certificate issued at a discount was capital gain. Other circuits, however, thereafter held that income attributable to the discount was ordinary income. See, for example, Real Estate Investment Trust v. Commissioner, 334 F. 2d 986 (CA1 1964), cert. denied, 381 U. S. 911 (1965); Dixon v. United States, 333 F. 2d 1016 (CA2 1964), aff’d, 381 U. S. 68 (1965); United States v. Harrison, 304 F. 2d 835 (CA5 1962), cert. denied, 372 U. S. 934 (1963); Rosen v. United States, 288 F. 2d 658 (CA3 1961); Commissioner v. Morgan, 272 F. 2d 936 (CA9 1959).
      The issue was settled by the decision in United States v. Midland-Ross Corp., 381 U. S. 54 (1965), when the Court held that earned original issue discount is not entitled to capital gain treatment under the 1939 Code.
      Congress, in enacting § 1232 of the 1954 Code, adopted a different approach to earned original issue discount, referring to it as “a form of interest income” in S. Rep. No. 1622, 83d Cong., 2d Sess., 112 (1954). Under § 1232 (a) (2), gain from the sale or redemption of a corporate obligation issued at a discount is taxed as the gain from the sale of a noncapital asset. If the obligation is held by the original purchaser to maturity, the entire amount of the discount is so taxed, but if it is sold or redeemed before maturity, only the portion accrued up to the date of sale or redemption is so taxed. See De Kosmian, Original Issue Discount, 22 Tax Lawyer 339, 340-347 (1969); Zafft, Discount Bonds — Ordinary Income or Capital Gain?, 11 Tax L. Rev. 51 (1955).

       Judge Kalodner, joined by Judge Staley, observed, “The American Smelting decision in that respect must be limited to its facts.” 232 F. 2d, at 546.

       In Old Mission Portland Cement Co. v. Helvering, 293 U. S. 289 (1934), where original issue discount bonds were held by an affiliate of the issuing corporation, the Court concluded that a deduction for the discount was not available when the affiliated corporations filed a consolidated income tax return. The situation was related to that of a single taxpayer purchasing its own bonds prior to maturity. Because, viewing the affiliates as a single taxpaying entity, there was no obligation to pay the face amount at maturity, the issuer “could not afterwards deduct, from gross income, the amortized discount on the bonds, in anticipation of their payment at maturity.” Id., at 292. Here NAD incurred no additional obligation because of the substitution of its debentures for its preferred.

       While in no sense implying that the securities were equivalent, the Court in the past has noted that the investment difference between preferred shares and unsecured debentures can be of slight degree, and is further diminished when, as here, the debentures are subordinated. John Kelley Co. v. Commissioner, 326 U. S. 521 (1946).

       “We simply cannot overlook the complete lack of substance to the claims of the corporation here. Its assets were not diminished by a penny, either when the debentures were issued to the stockholders or where the face amount of the bonds was assumed by Fuqua (thus, presumably reducing the amount of the purchase price). The company paid nothing more to the bond-holders at any time than the current interest. It did not sell them to anyone at a discount. It issued them either as dividend, partial distribution of earned income and capital, or as ‘boot’ in a tax-free reorganization. It cannot deduct as interest what it has not paid out or become liable to pay out to anybody.” 469 F. 2d, at 344 n. 11.