author: Justice Marshall

text:
    EASTERN AIRLINES, INC. v. FLOYD et al.
    No. 89-1598.
    Argued October 29, 1990
    Decided April 17, 1991

      Marshall, J., delivered the opinion for a unanimous Court.

      John Michael Murray argued the cause for petitioner. With him on the briefs were Aitrora A. Ares and Linda Singer Stein.

      Joel D. Eaton argued the cause and filed a brief for respondents.
   Justice Marshall

delivered the opinion of the Court.

Article 17 of the Warsaw Convention sets forth conditions under which an international air carrier can be held liable for injuries to passengers. This case presents the question whether Article 17 allows recovery for mental or psychic injuries unaccompanied by physical injury or physical manifestation of injury.

I

On May 5, 1983, an Eastern Airlines flight departed from Miami, bound for the Bahamas. Shortly after takeoff, one of the plane’s three jet engines lost oil pressure. The flight crew shut down the failing engine and turned the plane around to return to Miami. Soon thereafter, the second and third engines failed due to loss of oil pressure. The plane began losing altitude rapidly, and the passengers were informed that the plane would be ditched in the Atlantic Ocean. Fortunately, after a period of descending flight without power, the crew managed to restart an engine and land the plane safely at Miami International Airport. 872 F. 2d 1462, 1466 (CA11 1989).

Respondents, a group of passengers on the flight, brought separate complaints against petitioner, Eastern Airlines, Inc. (Eastern), each claiming damages solely for mental distress arising out of the incident. The District Court entertained each complaint in a consolidated proceeding. Eastern conceded that the engine failure and subsequent prepreparations for ditching the plane amounted to an “accident” under Article 17 of the Convention but argued that Article 17 also makes physical injury a condition of liability. See In re Eastern Airlines, Inc., Engine Failure, Miami Int'l Airport, 629 F. Supp. 307, 312 (SD Fla. 1986). Relying on another federal court’s analysis of the French authentic text and negotiating history of the Convention, see Burnett v. Trans World Airlines, Inc., 368 F. Supp. 1152 (NM 1973), the District Court concluded that mental anguish alone is not compensable under Article 17. See 629 F. Supp., at 314.

The Court of Appeals for the Eleventh Circuit reversed, holding that the phrase “lésion corporelle” in the authentic French text of Article 17 encompasses purely emotional distress. See 872 F. 2d, at 1480. To support its conclusion, the court examined the French legal meaning of the the term “lésion corporelle,” the concurrent and subsequent history of the Convention, and cases interpreting Article 17. See id., at 1471-1480. We granted certiorari, 496 U. S. 904 (1990), to resolve a conflict between the Eleventh Circuit’s decision in this case and the New York Court of Appeals’ decision in Rosman v. Trans World Airlines, Inc., 34 N. Y. 2d 385, 314 N. E. 2d 848 (1974), which held that purely psychic trauma is not compensable under Article 17. We now hold that Article 17 does not allow recovery for purely mental injuries.

II

“When interpreting a treaty, we ‘begin “with the text of the treaty and the context in which the written words are used.”’” Volkswagenwerk Aktiengesellschaft v. Schlunk, 486 U. S. 694, 699 (1988), quoting Société Nationale Industrielle Aérospatiale v. United States District Court, 482 U. S. 522, 534 (1987), quoting Air France v. Saks, 470 U. S. 392, 397 (1985). Accord, Chan v. Korean Air Lines, Ltd., 490 U. S. 122, 134 (1989); Maximov v. United States, 373 U. S. 49, 53-54 (1963). “Other general rules of construction may be brought to bear on difficult or ambiguous passages.” Volksiuagenwerk, supra, at 700. Moreover, “‘treaties are construed more liberally than private agreements, and to ascertain their meaning we may look beyond the written words to the history of the treaty, the negotiations, and the practical construction adopted by the parties.’” Saks, supra, at 396, quoting Choctaw Nation of Indians v. United States, 318 U. S. 423, 431-432 (1943). Accord, Volkswagenwerk, supra, at 700. We proceed to apply these methods in turn.

A

Because the only authentic text of the Warsaw Convention is in French, the French text must guide our analysis. See Saks, supra, at 397-399. The text reads as follows:

“Le transporteur est responsable du dommage sur-venu en cas de mort, de blessure ou de toute autre lésion corporelle subie par un voyageur lorsque l’accident qui a causé le dommage s’est produit á bord de l’aéronef ou au cours de toutes operations d’embarquement et de dé-barquement.” 49 Stat. 3005 (emphasis added).

The American translation of this text, employed by the Senate when it ratified the Convention in 1934, reads:

“The carrier shall be liable for damage sustained in the event of the death or wounding of a passenger or any other bodily injury suffered by a passenger, if the accident which caused the damage so sustained took place on board the aircraft or in the course of any of the operations of embarking or disembarking.” 49 Stat. 3018 (emphasis added).

Thus, under Article 17, an air carrier is liable for passenger injury only when three conditions are satisfied: (1) there has been an accident, in which (2) the passenger suffered “mort,” “blessure,” “ou . . . toute autre lésion corporelle,” and (3) the accident took place on board the aircraft or in the course of operations of embarking or disembarking. As petitioner concedes, the incident here took place on board the aircraft and was an “accident” for purposes of Article 17. See 872 F. 2d, at 1471. Moreover, respondents concede that they suffered neither “mort” nor “blessure” from the mishap. Therefore, the narrow issue presented here is whether, under the proper interpretation of “lésion corporelle,” condition (2) is satisfied when a passenger has suffered only a mental or psychic injury.

We must consider the “French legal meaning” of “lésion corporelle” for guidance as to the shared expectations of the parties to the Convention because the Convention was drafted in French by continental jurists. See Saks, supra, at 399. Perhaps the simplest method of determining the meaning of a phrase appearing in a foreign legal text would be to consult a bilingual dictionary. Such dictionaries suggest that a proper translation of “lésion corporelle” is “bodily injury.” See, e. g., J. Jéraute, Vocabulaire Frangais-Anglais et Anglais-Frangais de Termes et Locutions Juridi-ques 205 (1953) (translating “bodily harm” or “bodily injury” as “lésion ou blessure corporelle”); see also id., at 95 (translating the term “lésion” as “injury, damage, prejudice, wrong”); id., at 41 (giving as one sense of “corporel” the English word “bodily”); 3 Grand Larousse de la Langue Frangaise 1833 (1987) (defining “lésion” as a “[mjodification de la structure d’un tissu vivant sous l’influence d’une cause morbide”). These translations, if correct, clearly suggest that Article 17 does not permit recovery for purely psychic injuries. Although we have previously relied on such French dictionaries as a primary method for defining terms in the Warsaw Convention, see Saks, supra, at 400, and n. 3, we recognize that dictionary definitions may be too general for purposes of treaty interpretation. Our concerns are partly allayed when, as here, the dictionary translation accords with the wording used in the “two main translations of the 1929 Convention in English.” Mankiewicz 197. As we noted earlier, the translation used by the United States Senate when ratifying the Warsaw Convention equated “lésion eorporelle” with “bodily injury.” See supra, at 535. The same wording appears in the translation used in the United Kingdom Carriage by Air Act of 1932. See L. Goldhirsch, The Warsaw Convention Annotated: A Legal Handbook 199, 204 (1988) (hereinafter Goldhirsch). We turn, then, to French legal materials, Saks, 470 U. S., at 400, to determine whether French jurists’ contemporary understanding of the term “lésion eorporelle” differed from its translated meaning.

In 1929, as in the present day, lawyers trained in French civil law would rely on the following principal sources of French law: (1) legislation, (2) judicial decisions, and (3) scholarly writing. See generally 1 M. Planiol & G. Ripert, Traité élémentaire de droit civil, pt. 1, Nos. 10, 122, 127 (12th ed. 1939) (Louisiana State Law Inst, trans. 1959); F. Gény, Méthode d’Interprétation et Sources en Droit Privé Positif Nos. 45-50 (2d ed. 1954) (Louisiana State Law Inst, trans. 1963); R. David, French Law: Its Structure, Sources, and Methodology 154 (M. Kindred trans. 1972). Our review of these materials indicates neither that “lésion corporelle” was a widely used legal term in French law nor that the term specifically encompassed psychic injuries.

Turning first to legislation, we find no French legislative provisions in force in 1929 that contained the phrase “lésion corporelle.” The principal provision of the French Civil Code relating to the scope of compensable injuries appears to be Article 1382, which provides in very general terms: “Tout fait quelconque de l’homme, qui cause á autrui un dommage, oblige celui par la faute duquel il est. . . arrivé, á le réparer.” See 2 Planiol & Ripert, supra, at pt. 1, No. 863 (translating Article 1382 as, “Every act whatever of man which causes damage to another obliges him by whose fault it happened to repair it”).

Turning next to cases, we likewise discover no French court decisions in or before 1929 that explain the phrase “lésion corporelle,” nor do the parties direct us to any. Indeed, we find no French case construing Article 17 of the Warsaw Convention to cover psychic injury. The only reports of French cases we did find that used the term “lésion cor-porelle” are relatively recent and involve physical injuries caused by automobile accidents and other incidents. These cases tend to support the conclusion that, in French legal usage, the term “lésion corporelle” refers only to physical injuries. However, because they were decided well after the drafting of the Warsaw Convention, these cases do not necessarily reflect the contracting parties’ understanding of the term “lésion corporelle.”

Turning finally to French treatises and scholarly writing covering the period leading up to the Warsaw Convention, we find no materials (and the parties have brought none to our attention) indicating, that “lésion corporelle” embraced psychic injury. Subsequent to the adoption of the Warsaw Convention, some scholars have argued that “lésion cor-porelle” as used in Article 17 should be interpreted to encompass such inj.ury. See, e. g., Mankiewicz 146 (arguing that “in French law the expression lésion corporelle covers any ‘personal’ injury whatsoever”); G. Miller, Liability in International Air Transport 128 (1977) (hereinafter Miller) (arguing that “a liberal interpretation of [Article 17] would be more in line with the spirit of the Convention”). These scholars draw on the fact that, by 1929, France — unlike many other countries, see infra, at 544-545, and n. 10 — permitted tort recovery for mental distress. See, e. g., 2 Planiol & Ripert, supra, at pt. 1, No. 868A (citing cases awarding damages for injury to honor and for loss of affection). However, this general proposition of French tort law does not demonstrate that the specific phrase chosen by the contracting parties — “lésion corporelle” — covers purely psychic injury.

We find it noteworthy, moreover, that scholars who read “lésion corporelle” as encompassing psychic injury do not base their argument on explanations of this term in French cases or French treatises or even in the French Civil Code; rather, they chiefly rely on the principle of French tort law that any damage can “giv[e] rise to reparation when it is real and has been verified.” 2 Planiol & Ripert, supra, at pt. 1, No. 868. We do not dispute this principle of French law. However, we have been directed to no French case prior to 1929 that allowed recovery based on that principle for the type of mental injury claimed here — injury caused by fright or shock — absent an incident in which someone sustained physical injury. Since our task is to “give the specific words of the treaty a meaning consistent with the shared expectations of the contracting parties,” Saks, supra, at 399, we find it unlikely that those parties’ apparent understanding of the term “lésion corporelle” as “bodily injury” would have been displaced by a meaning abstracted from the French law of damages. Particularly is this so when the cause of action for psychic injury that evidently was possible under French law in 1929 would not have been recognized in many other countries represented at the Warsaw Convention. See infra, at 544-545, and n. 10.

Nor is this conclusion altered by our examination of Article 17’s structure. In the decision below, the Court of Appeals found that the Article’s wording “suggests that the drafters did not intend to exclude any particular category of damages,” because if they had intended “to refer only to injury caused by physical impact,” they “would not have singled out and specifically referred to a particular case of physical impact such as blessure (‘wounding’).” 872 F. 2d, at 1472-1473 (citing Mankiewicz 146). This argument, which has much the same force as the surplusage canon of domestic statutory construction, is plausible. Cf. Reiter v. Sonotone Corp., 442 U. S. 330, 339 (1979). Yet one might draw a contrary inference from the same language. As noted, one meaning of “lésion” is a change in the structure of an organ due to injury or disease. See supra, at 536, citing 3 Grand Larousse de la Langue Frangaise 1833 (1987). If “blessure” refers to injuries causing visible ruptures in the body (a common meaning of a “wounding”), “lésion corporelle” might well refer to a more general category of physical injuries that includes internal injuries caused, for example, by physical impact, smoke or exhaust inhalation, or oxygen deprivation. Admittedly, this inference still runs afoul of the Court of Appeals’ surplus-age argument. However, because none of the other sources of French legal meaning noted above support the Court of Appeals’ construction, we are reluctant to give this argument dispositive weight.

The same structural argument offered by the Court of Appeals was advanced by one of the German delegates to the Warsaw Convention. See Palagonia v. Trans World Airlines, 110 Misc. 2d 478, 483, 442 N. Y. S. 2d 670, 673-674 (Sup. 1978) (quoting testimony of Otto Riese). Accordingly, the official German translation of “lésion corporelle” adopted by Austria, Germany, and Switzerland uses German terms whose closest English translation is apparently “infringement on the health.” See Mankiewicz 146. We are reluctant, however, to place much weight on an English translation of a German translation of a French text, particularly when we have been unable to find (and the parties have not cited) any German, Austrian, or Swiss cases adhering to the broad interpretation of Article 17 that the German delegate evidently espoused.

In sum, neither the Warsaw Convention itself nor any of the applicable French legal sources demonstrates that “lésion corporelle” should be translated other than as “bodily injury” — a narrow meaning excluding purely mental injuries. However, because a broader interpretation of “lésion cor-porelle” reaching purely mental injuries is plausible, and the term is both ambiguous and difficult, see supra, at 535, we turn to additional aids to construction.

B

Translating “lésion corporelle” as “bodily injury” is consistent, we think, with the negotiating history of the Convention. “The treaty that became the Warsaw Convention was first drafted at an international conference in Paris in 1925.” Air France v. Saks, 470 U. S., at 401; see also Chan v. Korean Air Lines, Ltd., 490 U. S., at 139 (Brennan, J., concurring in judgment). See generally [1925 Paris] Conférence Internationale de Droit Privé Aérien (1936) (hereinafter Paris Conference). The final protocol of the Paris Conference contained an article specifying that: “ ‘The carrier is liable for accidents, losses, breakdowns, and delays. It is not liable if it can prove that it has taken reasonable measures designed to pre-empt damage ....’” Saks, supra, at 401, translating Article 5 of the protocol, Paris Conference 87. It appears that “[t]his expansive provision, broadly holding carriers liable in the event of an accident, would almost certainly have permitted recovery for all types of injuries, including emotional distress.” Sisk, Recovery for Emotional Distress Under the Warsaw Convention: The Elusive Search for the French Legal Meaning of Lésion Corporelle, 25 Texas Int’l L. J. 127, 142 (1990), citing Miller 124.

The Paris Conference appointed a committee of experts, the Comité International Technique d’Experts Juridiques Aériens (CITEJA), to revise its final protocol for presentation to the Warsaw Conference. See Chan, supra, at 139 (Brennan, J., concurring in judgment); Saks, supra, at 401. The CITEJA draft split the liability article of the Paris Conference’s protocol into three provisions with one addressing damages for injury to passengers, the second addressing injury to goods, and the third addressing losses caused by delay. The CITEJA subsection on injury to passengers introduced the phrase “en cas de mort, de blessure ou de toute autre lésion corporelle.” [Deuxiéme] Conférence Internationale de Droit Privé Aérien, 4-12 Octobre 171-172 (1929) (Article 21, subsection (a) of the CITEJA draft). This language was retained in Article 17 ultimately adopted by the Warsaw Conference. See 49 Stat. 3005. Although there is no definitive evidence explaining why the CITEJA drafters chose this narrower language, we believe it is reasonable to infer that the Conference adopted the narrower language to limit the types of recoverable injuries. Cf. Volkswagenwerk Aktiengesellschaft v. Schlunk, 486 U. S., at 700-701 (noting significance of change in negotiating history of Hague Service Convention from less precise term in draft to more precise term in final treaty provision).

Our review of the documentary record for the Warsaw Conference confirms — and courts and commentators appear universally to agree — that there is no evidence that the drafters or signatories of the Warsaw Convention specifically considered liability for psychic injury or the meaning of “lésion corporelle.” See generally Minutes. Two explanations commonly are offered for why the subject of mental injuries never arose during the Convention proceedings: (1) many jurisdictions did not recognize recovery for mental injury at that time, or (2) the drafters simply could not contemplate a psychic injury unaccompanied by a physical injury. See, e. g., Husserl v. Swiss Air Transport Co., 388 F. Supp. 1238, 1249 (SDNY 1975) (Husserl II); Cie Air France v. Teichner, 39 Revue Française de Droit Aérien 232, 242, 23 Eur. Tr. L. 87, 101 (Israel 1984); Mankiewicz 144-145; Miller 123-125. Indeed, the unavailability of compensation for purely psychic injury in many common and civil law countries at the time of the Warsaw Conference persuades us that the signatories had no specific intent to include such a remedy in the Convention. Because such a remedy was unknown in many, if not most, jurisdictions in 1929, the drafters most likely would have felt compelled to make an unequivocal reference to purely mental injury if they had specifically intended to allow such recovery.

In this sense, we find it significant that, when the parties to a different international transport treaty wanted to make it clear that rail passengers could recover for purely psychic harms, the drafters made a specific modification to this effect. The liability provision of the Berne Convention on International Rail, drafted in 1952, originally conditioned liability on “la mort, les blessures et toute autre atteinte, á Tintégrité corporelle.” International Convention Concerning the Carriage of Passengers and Luggage By Rail, Berne, Oct. 25, 1952, 242 U. N. T. S. 355, Article 28, p. 390. The drafters subsequently modified this provision to read ‘Tin-tégrité physique ou mentale.” See Additional Convention to the International Convention Concerning the Carriage of Passengers and Luggage by Rail (CIV) of Feb. 25, 1961, Relating to the Liability of the Railway for Death of and Personal Injury to Passengers, done Feb. 26, 1966, Art. 2, reprinted in Transport: International Transport Treaties V-52 (Kluwer Publishers) (Supp. 1-10, Jan. 1986) (emphasis added).

The narrower reading of “lésion corporelle” also is consistent with the primary purpose of the contracting parties to the Convention: limiting the liability of air carriers in order to foster the growth of the fledgling commercial aviation industry. See Trans World Airlines, Inc. v. Franklin Mint Corp., 466 U. S. 243, 256 (1984); Minutes 37; Lowenfeld & Mendelsohn, The United States and The Warsaw Convention, 80 Harv. L. Rev. 497, 498-499 (1967) (hereinafter Lowenfeld & Mendelsohn). Indeed, it was for this reason that the Warsaw delegates imposed a maximum recovery of $8,300 for an accident — a low amount even by 1929 standards. See Lowenfeld & Mendelsohn 498-499. Whatever may be the current view among Convention signatories, in 1929 the parties were more concerned with protecting air carriers and fostering a new industry than providing full recovery to injured passengers, and we read “lésion corporelle” in a way that respects that legislative choice.

C

We also conclude that, on balance, the evidence of the post-1929 “conduct” and “interpretations of the signatories,” Saks, 470 U. S., at 403, supports the narrow translation of “lésion corporelle.”

In the years following adoption of the Convention, some scholars questioned whether Article 17 extended to mental or emotional injury. See, e. g., Beaumont, Need for Revision and Amplification of the Warsaw Convention, 16 J. Air L. & Com. 395, 402 (1949); R. Coquoz, Le Droit Privé International Aérien 122 (1938); Sullivan, The Codification of Air Carrier Liability by International Convention, 7 J. Air L. 1, 19 (1936). In 1951, a committee composed of 20 Warsaw Convention signatories met in Madrid and adopted a proposal to substitute “affection corporelle” for “lésion corporelle” in Article 17. See International Civil Aviation Organization Legal Committee, Minutes and Documents of the Eighth Session, Madrid, ICAO Doc. 7229-LC/133, pp. xiii, 137 (1951). The French delegate to the committee proposed this substitution because, in his view, the word “lésion” was too narrow, in that it “presupposed a rupture in the tissue, or a dissolution of continuity” which might not cover an injury such as mental illness or lung congestion caused by a breakdown in the heating apparatus of the aircraft. See id., at 136. The United States delegate opposed this change if it “implied the inclusion of mental injury or emotional disturbances or upsets which were not connected with or the result of bodily injury,” see id., at 137, but the committee adopted it nonetheless, see ibid. Although the committee’s proposed amendment was never subsequently implemented, its discussion and vote in Madrid suggest that, in the view of the 20 signatories on the committee, “lésion corporelle” in Article 17 had a distinctly physical scope.

In finding that the signatories’ post-1929 conduct supports the broader interpretation of “lésion corporelle,” the Court of Appeals relied on three international agreements: The Hague Protocol of 1955, The Montreal Agreement of 1966, and the Guatemala City Protocol of 1971. See 872 F. 2d, at 1474-1475. For each of these agreements, the Court of Appeals emphasized that English translations rendered “lésion corpo-relle” as “personal injury,” instead of “bodily injury.” In our view, none of these agreements support the broad interpretation of “lésion corporelle” reached by the Court of Appeals.

The Hague Protocol amended Article 3 of the Warsaw Convention, which sets forth the particular information a passenger’s ticket must contain, to require notice of the limitation upon the carrier’s liability for passenger injuries under the Convention. See Hague Protocol Article III, reprinted in Goldhirsch 266. While the authentic French version of Article 3 retained the phrase “lésion corporelle,” the authentic English version of the Hague Protocol, which was proposed by the United States delegation, used the phrase “personal injury.” See 2 International Civil Aviation Organization, International Conference on Private Air Law, The Hague, Sept. 1955, ICAO Doc. 7686-LC/140, p. 243 (proposal of the United States); see also Goldhirsch 266 (citing final version of Hague Protocol). Citing Saks, the Court of Appeals treated the Hague Protocol’s use of “personal injury” as a “ ‘subsequent interpretation] of the signatories’ ” that “helps clarify the meaning” of “lésion corporelle.” See 872 F. 2d, at 1474-1475. However, we do not accept the argument that the Hague Protocol signatories intended “personal injury” to be an interpretive translation of “lésion corporelle” where there is no evidence that they intended the authentic English text to effect a substantive change in, or clarification of that term. Moreover, the portion of Article 3 of the Hague Protocol in which “personal injury” appears is concerned solely with informing passengers that when the convention “governs” it “in most eases limits the liability of carriers for death or personal injury.” See supra, n. 13. It may be, therefore, that the signatories used “personal injury” not as an interpretive translation of “lésion corporelle” but merely as a way of giving a summary description of the limitations of liability imposed by the Convention.

The Montreal Agreement of 1966 is similarly inconclusive. The Agreement, which affects only international flights with connecting points in the United States, raised the limit of accident liability to $75,000 and waived due-care defenses. See Montreal Agreement, reprinted in Goldhirsch 317-318; Lowenfeld & Mendelsohn 596-597. The Court of Appeals noted that, under the Montreal Agreement, the notice appearing on passenger tickets used the term “personal injury” rather than “bodily injury” and that the United States Civil Aeronautics Board used these terms interchangeably in approving the Agreement. 872 F. 2d, at 1474. For two reasons, we do not believe that this evidence bears on the signatories’ understanding of “lésion corporelle” in Article 17. First, as the Court of Appeals acknowledged, “[t]he Montreal Agreement is not a treaty, but rather an agreement among all major international air carriers that imposes a quasi-legal and largely experimental system of liability essentially contractual in nature.” Id., at 1468-1469. Therefore, the Montreal Agreement does not and cannot purport to speak for the signatories to the Warsaw Convention. Second, the Montreal Agreement does not purport to change or clarify the provisions of Article 17.

We likewise do not believe that the Guatemala City Protocol of 1971 sheds any light upon the intended scope of Article 17. The Protocol was drafted in three authentic texts, English, French, and Spanish, but the French text was to control in cases of conflict. See Guatemala City Protocol Article XXVI, reprinted in Goldhirsch 329. The Protocol amended the French text of Article 17 by deleting the word “blessure,” while retaining “lésion corporelle.” See 2 International Civil Aviation Organization, International Conference on Air Law, Guatemala City, ICAO Doc. 9040-LC/167-2, p. 183 (1972). Additionally, the English text of the Protocol substituted “personal injury” for “wounding or other bodily injury” in Article 17. See Guatemala City Protocol Article IV, reprinted in Goldhirsch 320-321. The Court of Appeals read the changes in both the French and English versions of Article 17 as supporting an interpretation of “lésion corporelle” broader than “bodily injury.” See 872 F. 2d, at 1475.

For several reasons, however, we disagree. First, there is no evidence that the changes to the English or French text were intended to effect a substantive change or clarification. Cf. Miller 123 (noting that the change to the English text was inconspicuously proposed by a drafting group of the ICAO Legal Committee as a minor drafting improvement). Neither mental injuries nor the minor drafting changes were discussed at the Guatemala City Conference. See 1 International Civil Aviation Organization, International Conference on Air Law, Minutes, Guatemala City, ICAO Doc. 9040-LC/167-1, pp. 31-38, 41-63 (1972). Second, of the approximately 120 signatories to the Warsaw Convention, only a few countries have actually ratified the Guatemala City Protocol, see Mankiewicz 237, and therefore the Protocol is not in effect in the international arena. Likewise, we have stated that because the United States Senate has not ratified the Protocol we should not consider it to be dispositive. See Saks, supra, at 403.

We must also consult the opinions of our sister signatories in searching for the meaning of a “lésion corporelle.” See Saks, 470 U. S., at 404. The only apparent judicial decision from a sister signatory addressing recovery for purely mental injuries under Article 17 is that of the Supreme Court of Israel. That court held that Article 17 does allow recovery for purely psychic injuries. See Cie Air France v. Teichner, 39 Revue Française de Droit Aérien, at 243, 23 Eur. Tr. L., at 102.

Teichner arose from the hijacking in 1976 of an Air France flight to Entebbe, Uganda. Passengers sought compensation for psychic injuries caused by the ordeal of the hijacking and detention at the Entebbe Airport. While acknowledging that the negotiating history of the Warsaw Convention was silent as to the availability of such compensation, id., at 242, 23 Eur. Tr. L., at 101, the court determined that “desirable jurisprudential policy” (“la politique jurisprudentielle souhaitable”) favored an expansive reading of Article 17 to reach purely psychic injuries. Id., at 243, 23 Eur. Tr. L., at 102. In reaching this conclusion, the court emphasized the post-1929 development of the aviation industry and the evolution of Anglo-American and Israeli law to allow recovery for psychic injury in certain circumstances. Ibid., 23 Eur. Tr. L., at 101-102. In addition, the court followed the view of Miller that this expansive construction was desirable to avoid an apparent conflict between the French and English versions of the Guatemala City Protocol. Id., at 243-244, 23 Eur. Tr. L., at 102, citing Miller 128-129.

Although we recognize the deference owed to the Israeli court’s interpretation of Article 17, see Saks, supra, at 404, we are not persuaded by that court’s reasoning. Even if we were to agree that allowing recovery for purely psychic injury is desirable as a policy goal, we cannot give effect to such policy without convincing evidence that the signatories’ intent with respect to Article 17 would allow such recovery. As discussed, neither the language, negotiating history, nor postenactment interpretations of Article 17 clearly evidences such intent. Nor does the Guatemala City Protocol support the Israeli court’s conclusion because nothing in the Protocol purports to amend Article 17 to reach mental injuries. Moreover, although the Protocol reflects a liberalization of attitudes toward passenger recovery in that it provides for strict liability, see Article IV, reprinted in Goldhirsch 320, the fact that the Guatemala City Protocol is still not in effect after almost 20 years since it was drafted should caution against attaching significance to it.

Moreover, we believe our construction of Article 17 better accords with the Warsaw Convention’s stated purpose of achieving uniformity of rules governing claims arising from international air transportation. See n. 11, supra. As noted, the Montreal Agreement subjects international carriers to strict liability for Article 17 injuries sustained on flights connected with the United States. See supra, at 549. Recovery for mental distress traditionally has been subject to a high degree of proof, both in this country and others. See Prosser and Keeton on Torts, at 60-65, 359-361 (American courts require extreme and outrageous conduct by the tort-feasor); Fleming 49-50 (British courts limit such recovery through the theory of foreseeabilty); Miller 114, 126 (French courts require proof of fault and proof that damage is direct and certain). We have no doubt that subjecting international air carriers to strict liability for purely mental distress would be controversial for most signatory countries. Our construction avoids this potential source of divergence.

t — l h — I

We conclude that an air carrier cannot be held liable under Article 17 when an accident has not caused a passenger to suffer death, physical injury, or physical manifestation of injury. Although Article 17 renders air carriers liable for “damage sustained in the event of” (“dommage survenu en cas de”) such injuries, see 49 Stat. 3005, 3018, we express no view as to whether passengers can recover for mental injuries that are accompanied by physical injuries. That issue is not presented here because respondents do not allege physical injury or physical manifestation of injury. See App. 3-9.

Eastern urges us to hold that the Warsaw Convention provides the exclusive cause of action for injuries sustained during international air transportation. The Court of Appeals did not address this question, and we did not grant certiorari to consider it. We therefore decline to reach it here.

The judgment of the Court of Appeals is reversed.

It is so ordered.

       Convention for the Unification of Certain Rules Relating to International Transportation by Air, Oct. 12, 1929, 49 Stat. 3000, T. S. No. 876 (1934), note following 49 U. S. C. App. § 1502 (hereinafter Warsaw Convention or Convention).

       Each complaint contained two state-law tort claims, a state-law claim for breach of contract, and a claim for recovery under the Warsaw Convention. In re Eastern Airlines, Inc., Engine Failure, Miami Int'l Airport, 629 F. Supp. 307, 309 (SD Fla. 1986). The District Court dismissed all claims. Ibid. We address only the theory of recovery claimed under the Warsaw Convention.

       Courts of first instance also have disagreed on this issue. Compare Borham v. Pan American World Airways, 19 Aviation Cases 18,236 (CCH) (SDNY 1986) (purely mental injury covered); and Karfunkel v. Compagnie Nationale Air France, 427 F. Supp. 971 (SDNY 1977) (same); and Krystal v. British Overseas Airways Corp., 403 F. Supp. 1322 (CD Cal. 1975) (same); and Husserl v. Swiss Air Transport Co., 388 F. Supp. 1238 (SDNY 1975) (Husserl II) (same); and Palagonia v. Trans World Airlines, 110 Misc. 2d 478, 442 N. Y. S. 2d 670 (Sup. 1978) (same) with Burnett v. Trans World Airlines, Inc., 368 F. Supp. 1152 (NM 1973) (excluding purely mental injury); and Husserl v. Swiss Air Transport Co., 351 F. Supp. 702 (SDNY 1972) (Husserl I), aff’d, 485 F. 2d 1240 (CA2 1973) (same).

       Courts and commentators agree that “blessure” refers only to “a particular case of physical impact,” 872 F. 2d 1462, 1472-1473 (CA11 1989), and thus does not by itself allow recovery for purely psychic harm. See also R. Mankiewicz, The Liability Regime of the International Air Carrier 146 (1981) (hereinafter Mankiewicz). Respondents do not contend that “blessure” has any other meaning.

       There is much agreement even among courts that believe that “lésion eorporelle” does provide recovery for such injuries that, if “bodily injury” is the correct translation of “lésion eorporelle,” Article 17 does not permit recovery for purely psychic injuries. See, e. g., 872 F. 2d, at 1471 (“While the use of the word eorporelle would, if read literally, appear to imply that recovery for dommage mentale is unavailable, we are persuaded that this literal reading is unwarranted”); Palagonia v. Trans World Airlines, supra, at 482, 442 N. Y. S. 2d, at 673 (arguing that “[t]he dictionary or literal translation of lésion eorporelle as ‘bodily injury’ is not accurate as used in a legal document”). But see, Husserl II, supra, at 1250 (arguing that “bodily injury” “can ... be construed to relate to emotional and mental injury”).

       In the several such cases that we found, there was no evidence that French courts would use the term “lésion corporelle” to describe purely psychic injuries. In one case, for example, the highest French court of ordinary jurisdiction, the Cour de Cassation, specifically distinguished “coups et blessures volontaires” (“intentional blows and injuries”) sustained by the plaintiff — which the court characterized as “lésions” — from “[les] troubles de nature névrotique” (“neurotic disorders”) from which the plaintiff suffered as a result of a prior incident. See Judgment of November 4, 1971, Cour de Cassation, 1971 Bull. Civ. II 219, 220.

       Of the two eases cited by Mankiewicz to demonstrate that French law did compensate mental injuries, one involved recovery by a stepdaughter for emotional distress resulting from the death of her stepmother and the other involved recovery for injury to honor arising from adultery. See Mankiewicz 145 (citing decisions of the highest French court in 1923 and 1857). See also 11 International Encyclopedia of Comparative Law: Torts ch. 9, § 9-39, pp. 16-17, and nn. 114-115 (A. Tunc ed. 1972) (citing, as the first personal injury cases permitting recovery for nonpecuniary damages, an 1833 French decision in which “counsel for the plaintiff took as an illustration of dommage moral for which recovery should be permitted the grief of a family upon the death of one of their members” and an 1881 Belgian decision in a wrongful death case). Whether the “shared expectation” of the Warsaw Convention parties was that the distress experienced by relatives of injured or dead airline passengers qualified under Article 17 as “dommage survenu en cas de mort, [ou] de blessure . . . subie par un voyageur” (“damage sustained in the event of the death or wounding of a passenger”) is a different question from whether psychic injury actually suffered by a passenger is encompassed by the term “lésion corporelle.”

       re will refer to these alternative interpretations of “lésion corporelle” as the “narrow” and “broad” readings of the term.

       Courts and commentators, including the Court of Appeals, have cited the doctoral thesis of a French scholar, Yvonne Blanc-Dannery, as extrinsic evidence of the Warsaw parties’ intent. See, e. g., 872 F. 2d, at 1472; Palagonia, 110 Misc. 2d, at 482, 442 N. Y. S. 2d, at 673; Mankiewicz 146. According to Mankiewicz, the Blanc-Dannery thesis was written under the supervision of Georges Ripert. Mankiewicz 146, citing Blanc-Dannery, La Convention de Varsovie et les Régles du Transport Aérien International (1933) (hereinafter Blanc-Dannery). Georges Ripert was a leading French delegate at the Warsaw Convention and an expert of the French Government at the CITEJA proceedings. Minutes, Second International Conference on Private Aeronautical Law, October 4-12,1929, Warsaw 6 (R. Hor-ner & D. Legrez trans. 1975) (hereinafter Minutes). Mankiewicz translates a passage from the Blanc-Dannery thesis as follows: “ ‘The use of the expression lésion after the words ‘death’ and ‘wounding’ encompasses and contemplates cases of traumatism and nervous troubles, the consequences of which do not immediately become manifest in the organism but which can be related to the accident.’ ” Mankiewicz 146. Eastern offers persuasive evidence that Mankiewicz’s translation may be overbroad. See Reply Brief for Petitioner 2 (noting that the French word “perturbations” should be translated to connote a disturbance or aberration in a bodily organ or function rather than mere traumatisms or nervous troubles). Even if Mankiewicz’s translation is accurate, however, Blane-Dannery’s asserted definition is not supported by evidence from the CITEJA or Warsaw proceedings. See Blanc-Dannery 62. In the absence of such support we find the Blanc-Dannery thesis to have little or no value as evidence of the drafters’ intent.

       Although French law recognized recovery for certain types of mental distress long before the Convention was drafted, see Mankiewicz 145, in common-law jurisdictions mental distress generally was excluded from recovery in 1929. See Miller 113. Such recovery was not definitively recognized in the United Kingdom until the early 1940’s. See Mankiewicz 145; J. Fleming, Law of Torts 49 (1985) (hereinafter Fleming). American courts insisted on a physical impact rule long after English courts abandoned the practice. See ibid.; W. Keeton, D. Dobbs, R. Keeton, & D. Owen, Prosser and Keeton on Law of Torts § 54, p. 363 (5th ed. 1984). In the State of New York, where many Warsaw Convention cases have been litigated, recovery for purely mental injury was not recognized until 1961. See Mankiewicz 145, citing Battalia v. State, 10 N. Y. 2d 237, 176 N. E. 2d 729 (1961); see also Miller 113-115 (noting the post-1929 liberalization of rules for tort recovery in the United Kingdom and the United States). Several of the civil law and socialist signatories to the Warsaw Convention were slow to recognize recovery for nonpecuniary losses such as pain and suffering, grief caused by the death of a relative, or mental distress. See 11 International Encyclopedia of Comparative Law: Torts, Ch. 9, §§ 9-39, 9-40. The Netherlands, for example, did not permit nonpecuniary damages until 1943, and the German and Swiss Civil Codes generally barred nonpecuniary damages, though with certain exceptions — including an exception for cases of personal injury. See id., at § 9-41. In addition, the Soviet Union, another original signatory, has never recognized compensation for nonpecuniary loss. Id., at § 9-37. In countries barring recovery for nonpecuniary losses, recovery for mental injuries might have been available where financial loss could be shown, however, we are not aware of any such cases.

       The second goal of the Convention was to establish uniform rules governing documentation such as airline tickets and waybills and uniform procedure for addressing claims arising out of international transportation. See Minutes 85, 87; Lowenfeld & Mendelsohn 499. Our construction of “lésion corporelle” also is consistent with that goal. See infra, at 552.

       The Hague Protocol also amended the Convention to double the limit of liability for accidents to $16,600. See Hague Protocol Article XI, reprinted in Goldhirsch 268-269; Lowenfeld & Mendelsohn 507-509.
      At the Hague Conference, the signatories were presented with a proposal to amend Article 17 to cover purely mental injuries. The Greek delegation proposed adding the word “mental” to Article 17 because it was “not clear” whether Article 17 allowed recovery for such injury. See 1 International Civil Aviation Organization, International Conference on Private Air Law, The Hague, Sept. 1955, ICAO Doc. 7686-LC/140, p. 261. No one seconded this proposal. Ibid. In the absence of further discussion by the delegates, we cannot infer much from that fact.

       According to the English text of the final version, passenger tickets must contain
      “a notice to the effect that, if the passenger’s journey involves an ultimate destination or stop in a country other than the country of departure, the Warsaw Convention may be applicable and that the Convention governs and in most cases limits the liability of carriers for death or personal injury and in respect of loss of or damage to baggage. ” Goldhirsch 266 (emphasis added).
      The French version of the text emphasized above reads: “en cas de mort ou de lésion corporelle.” Id., at 256.

       In the only published versions that we could find, the Israeli opinion is reported in French.


source: Caselaw Access Project

author: Justice Marshall Justice Blackmun,

license: Public Domain

text:
    COTTAGE SAVINGS ASSOCIATION v. COMMISSIONER OF INTERNAL REVENUE
    No. 89-1965.
    Argued January 15, 1991
    Decided April 17, 1991

      Marshall, J., delivered the opinion of the Court, in which Rehnquist, C. J., and Stevens, O’Connor, Scalia, Kennedy, and Souter, JJ., joined. Blackmun, J., filed a dissenting opinion, in which White, J., joined, post, p. 568.

      Dennis L. Manes argued the cause for petitioner. With him on the briefs was Scott M. Slovin.

      Acting Solicitor General Roberts argued the cause for respondent. With him on the brief were Assistant Attorney General Peterson, Deputy Solicitor General Wallace, Clifford M. Sloan, Richard Farber, and Bruce R. Ellisen.

   Justice Marshall

delivered the opinion of the Court.

The issue in this case is whether a financial institution realizes tax-deductible losses when it exchanges its interests in one group of residential mortgage loans for another lender’s interests in a different group of residential mortgage loans. We hold that such a transaction does give rise to realized losses.

I

Petitioner Cottage Savings Association (Cottage Savings) is a savings and loan association (S & L) formerly regulated by the Federal Home Loan Bank Board (FHLBB). Like many S & L’s, Cottage Savings held numerous long-term, low-interest mortgages that declined in value when interest rates surged in the late 1970’s. These institutions would have benefited from selling their devalued mortgages in order to realize tax-deductible losses. However, they were deterred from doing so by FHLBB accounting regulations, which required them to record the losses on their books. Reporting these losses consistent with the then-effective FHLBB accounting regulations would have placed many S & L’s at risk of closure by the FHLBB.

The FHLBB responded to this situation by relaxing its requirements for the reporting of losses. In a regulatory directive known as “Memorandum R-49,” dated June 27, 1980, the FHLBB determined that S & L’s need not report losses associated with mortgages that are exchanged for “substantially identical” mortgages held by other lenders. The FHLBB’s acknowledged purpose for Memorandum R-49 was to facilitate transactions that would generate tax losses but that would not substantially affect the economic position of the transacting S & L’s.

This case involves a typical Memorandum R-49 transaction. On December 31, 1980, Cottage Savings sold “90% participation interests” in 252 mortgages to four S & L’s. It simultaneously purchased “90% participation interests” in 305 mortgages held by these S & L’s. All of the loans involved in the transaction were secured by single-family homes, most in the Cincinnati area. The fair market value of the package of participation interests exchanged by each side was approximately $4.5 million. The face value of the participation interests Cottage Savings relinquished in the transaction was approximately $6.9 million. See 90 T. C. 372, 378-382 (1988).

On its 1980 federal income tax return, Cottage Savings claimed a deduction for $2,447,091, which represented the adjusted difference between the face value of the participation interests that it traded and the fair market value of the participation interests that it received. As permitted by Memorandum R-49, Cottage Savings did not report these losses to the FHLBB. After the Commissioner of Internal Revenue disallowed Cottage Savings’ claimed deduction, Cottage Savings sought a redetermination in the Tax Court. The Tax Court held that the deduction was permissible. See 90 T. C. 372 (1988).

On appeal by the Commissioner, the Court of Appeals reversed. 890 F. 2d 848 (CA6 1989). The Court of Appeals agreed with the Tax Court’s determination that Cottage Savings had realized its losses through the transaction. See id., at 852. However, the court held that Cottage Savings was not entitled to a deduction because its losses were not “actually” sustained during the 1980 tax year for purposes of 26 U. S. C. § 165(a). See 890 F. 2d, at 855.

Because of the importance of this issue to the S & L industry and the conflict among the Circuits over whether Memorandum R-49 exchanges produce deductible tax losses, we granted certiorari. 498 U. S. 808 (1990). We now reverse.

\ — t t-H

Rather than assessing tax liability on the basis of annual fluctuations in the value of a taxpayer’s property, the Internal Revenue Code defers the tax consequences of a gain or loss in property value until the taxpayer “realizes” the gain or loss. The realization requirement is implicit in § 1001(a) of the Code, 26 U. S. C. § 1001(a), which defines “[t]he gain [or loss] from the sale or other disposition of property” as the difference between “the amount realized” from the sale or disposition of the property and its “adjusted basis.” As this Court has recognized, the concept of realization is “founded on administrative convenience.” Helvering v. Horst, 311 U. S. 112, 116 (1940). Under an appreciation-based system of taxation, taxpayers and the Commissioner would have to undertake the “cumbersome, abrasive, and unpredictable administrative task” of valuing assets on an annual basis to determine whether the assets had appreciated or depreciated in value. See 1 B. Bittker & L. Lokken, Federal Taxation of Income, Estates and Gifts ¶5.2, p. 5-16 (2d ed. 1989). In contrast, “[a] change in the form or extent of an investment is easily detected by a taxpayer or an administrative officer.” R. Magill, Taxable Income 79 (rev. ed. 1945).

Section 1001(a)’s language provides a straightforward test for realization: to realize a gain or loss in the value of property, the taxpayer must engage in a “sale or other disposition of [the] property.” The parties agree that the exchange of participation interests in this case cannot be characterized as a “sale” under § 1001(a); the issue before us is whether the transaction constitutes a “disposition of property.” The Commissioner argues that an exchange of property can be treated as a “disposition” under § 1001(a) only if the properties exchanged are materially different. The Commissioner further submits that, because the underlying mortgages were essentially economic substitutes, the participation interests exchanged by Cottage Savings were not materially different from those received from the other S & L’s. Cottage Savings, on the other hand, maintains that any exchange of property is a “disposition of property” under § 1001(a), regardless of whether the property exchanged is materially different. Alternatively, Cottage Savings contends that the participation interests exchanged were materially different because the underlying loans were secured by different properties.

We must therefore determine whether the realization principle in § 1001(a) incorporates a “material difference” requirement. If it does, we must further decide what that requirement amounts to and how it applies in this case. We consider these questions in turn.

A

Neither the language nor the history of the Code indicates whether and to what extent property exchanged must differ to count as a “disposition of property” under § 1001(a). Nonetheless, we readily agree with the Commissioner that an exchange of property gives rise to a realization event under § 1001(a) only if the properties exchanged are “materially different.” The Commissioner himself has by regulation construed § 1001(a) to embody a material difference requirement:

“Except as otherwise provided . . . the gain or loss realized from the conversion of property into cash, or from the exchange of property for other property differing materially either in kind or in extent, is treated as income or as loss sustained.” Treas. Reg. § 1.1001-1, 26 CFR § 1.1001-1 (1990) (emphasis added).

Because Congress has delegated to the Commissioner the power to promulgate “all needful rules and regulations for the enforcement of [the Internal Revenue Code],” 26 U. S. C. § 7805(a), we must defer to his regulatory interpretations of the Code so long as they are reasonable, see National Muffler Dealers Assn., Inc. v. United States, 440 U. S. 472, 476-477 (1979).

We conclude that Treasury Regulation § 1.1001-1 is a reasonable interpretation of § 1001(a). Congress first employed the language that now comprises § 1001(a) of the Code in § 202(a) of the Revenue Act of 1924, ch. 234, 43 Stat. 253; that language has remained essentially unchanged through various reenactments. And since 1934, the Commissioner has construed the statutory term “disposition of property” to include a “material difference” requirement. As we have recognized, “ ‘Treasury regulations and interpretations long continued without substantial change, applying to unamended or substantially reenacted statutes, are deemed to have received congressional approval and have the effect of law.’” United States v. Correll, 389 U. S. 299, 305-306 (1967), quoting Helvering v. Winmill, 305 U. S. 79, 83 (1938).

Treasury Regulation §1.001-1 is also consistent with our landmark precedents on realization. In a series of early decisions involving the tax effects of property exchanges, this Court made clear that a taxpayer realizes taxable income only if the properties exchanged are “materially” or “essentially” different. See United States v. Phellis, 257 U. S. 156, 173 (1921); Weiss v. Stearn, 265 U. S. 242, 253-254 (1924); Marr v. United States, 268 U. S. 536, 540-542 (1925); see also Eisner v. Macomber, 252 U. S. 189, 207-212 (1920) (recognizing realization requirement). Because these decisions were part of the “contemporary legal context” in which Congress enacted § 202(a) of the 1924 Act, see Cannon v. University of Chicago, 441 U. S. 677, 698-699 (1979), and because Congress has left undisturbed through subsequent reenactments of the Code the principles of realization established in these cases, we may presume that Congress intended to codify these principles in § 1001(a), see Pierce v. Underwood, 487 U. S. 552, 567 (1988); Lorillard v. Pons, 434 U. S. 575, 580-581 (1978). The Commissioner’s construction of the statutory language to incorporate these principles certainly was reasonable.

B

Precisely what constitutes a “material difference” for purposes of § 1001(a) of the Code is a more complicated question. The Commissioner argues that properties are “materially different” only if they differ in economic substance. To determine whether the participation interests exchanged in this case were “materially different” in this sense, the Commissioner argues, we should look to the attitudes of the parties, the evaluation of the interests by the secondary mortgage market, and the views of the FHLBB. We conclude that § 1001(a) embodies a much less demanding and less complex test.

Unlike the question whether § 1001(a) contains a material difference requirement, the question of what constitutes a material difference is not one on which we can defer to the Commissioner. For the Commissioner has not issued an authoritative, prelitigation interpretation of what property exchanges satisfy this requirement. Thus, to give meaning to the material difference test, we must look to the case law from which the test derives and which we believe Congress intended to codify in enacting and reenacting the language that now comprises § 1001(a). See Lorillard v. Pons, supra, at 580-581.

We start with the classic treatment of realization in Eisner v. Macomber, supra. In Macomber, a taxpayer who owned 2,200 shares of stock in a company received another 1,100 shares from the company as part of a pro rata stock dividend meant to reflect the company’s growth in value. At issue was whether the stock dividend constituted taxable income. We held that it did not, because no gain was realized. See id., at 207-212. We reasoned that the stock dividend merely reflected the increased worth of the taxpayer’s stock, see id., at 211-212, and that a taxpayer realizes increased worth of property only by receiving “something of exchangeable value proceeding from the property,” see id., at 207.

In three subsequent decisions—United States v. Phellis, supra; Weiss v. Stearn, supra; and Marr v. United States, supra—we refined Macomber*s conception of realization in the context of property exchanges. In each case, the taxpayer owned stock that had appreciated in value since its acquisition. And in each case, the corporation in which the taxpayer held stock had reorganized into a new corporation, with the new corporation assuming the business of the old corporation. While the corporations in Phellis and Marr both changed from New Jersey to Delaware corporations, the original and successor corporations in Weiss both were incorporated in Ohio. In each case, following the reorganization, the stockholders of the old corporation received shares in the new corporation equal to their proportional interest in the old corporation.

The question in these cases was whether the taxpayers realized the accumulated gain in their shares in the old corporation when they received in return for those shares stock representing an equivalent proportional interest in the new corporations. In Phellis and Marr, we held that the transactions were realization events. We reasoned that because a company incorporated in one State has “different rights and powers” from one incorporated in a different State, the taxpayers in Phellis and Marr acquired through the transactions property that was “materially different” from what they previously had. United States v. Phellis, 257 U. S., at 169-173; see Marr v. United States, supra, at 540-542 (using phrase “essentially different”). In contrast, we held that no realization occurred in Weiss. By exchanging stock in the predecessor corporation for stock in the newly reorganized corporation, the taxpayer did not receive “a thing really different from what he theretofore had.” Weiss v. Steam, supra, at 254. As we explained in Marr, our determination that the reorganized company in Weiss was not “really different” from its predecessor turned on the fact that both companies were incorporated in the same State. See Marr v. United States, supra, at 540-542 (outlining distinction between these cases).

Obviously, the distinction in Phellis and Marr that made the stock in the successor corporations materially different from the stock in the predecessors was minimal. Taken together, Phellis, Mart, and Weiss stand for the principle that properties are “different” in the sense that is “material” to the Internal Revenue Code so long as their respective possessors enjoy legal entitlements that are different in kind or extent. Thus, separate groups of stock are not materially different if they confer “the same proportional interest of the same character in the same corporation.” Marr v. United States, 268 U. S., at 540. However, they are materially different if they are issued by different corporations, id., at 541; United States v. Phellis, supra, at 173, or if they confer “different] rights and powers” in the same corporation, Marr v. United States, supra, at 541. No more demanding a standard than this is necessary in order to satisfy the administrative purposes underlying the realization requirement in § 1001(a). See Helvering v. Horst, 311 U. S., at 116. For, as long as the property entitlements are not identical, their exchange will allow both the Commissioner and the transacting taxpayer easily to fix the appreciated or depreciated values of the property relative to their tax bases.

In contrast, we find no support for the Commissioner’s “economic substitute” conception of material difference. According to the Commissioner, differences between properties are material for purposes of the Code only when it can be said that the parties, the relevant market (in this case the secondary mortgage market), and the relevant regulatory body (in this case the FHLBB) would consider them material. Nothing in Phellis, Weiss, and Marr suggests that exchanges of properties must satisfy such a subjective test to trigger realization of a gain or loss.

Moreover, the complexity of the Commissioner’s approach ill serves the goal of administrative convenience that underlies the realization requirement. In order to apply the Commissioner’s test in a principled fashion, the Commissioner and the taxpayer must identify the relevant market, establish whether there is a regulatory agency whose views should be taken into account, and then assess how the relevant market participants and the agency would view the transaction. The Commissioner’s failure to explain how these inquiries should be conducted further calls into question the workability of his test.

Finally, the Commissioner’s test is incompatible with the structure of the Code. Section 1001(c) of Title 26 provides that a gain or loss realized under § 1001(a) “shall be recognized” unless one of the Code’s nonrecognition provisions applies. One such nonrecognition provision withholds recognition of a gain or loss realized from an exchange of properties that would appear to be economic substitutes under the Commissioner’s material difference test. This provision, commonly known as the “like kind” exception, withholds recognition of a gain or loss realized “on the exchange of property held for productive use in a trade or business or for investment. . . for property of like kind which is to be held either for productive use in a trade or business or for investment.” 26 U. S. C. § 1031(a)(1). If Congress had expected that exchanges of similar properties would not count as realization events under § 1001(a), it would have had no reason to bar recognition of a gain or loss realized from these transactions.

C

Under our interpretation of § 1001(a), an exchange of property gives rise to a realization event so long as the exchanged properties are “materially different” — that is, so long as they embody legally distinct entitlements. Cottage Savings’ transactions at issue here easily satisfy this test. Because the participation interests exchanged by Cottage Savings and the other S & L’s derived from loans that were made to different obligors and secured by different homes, the exchanged interests did embody legally distinct entitlements. Consequently, we conclude that Cottage Savings realized its losses at the point of the exchange.

The Commissioner contends that it is anomalous to treat mortgages deemed to be “substantially identical” by the FHLBB as “materially different.” The anomaly, however, is merely semantic; mortgages can be substantially identical for Memorandum R-49 purposes and still exhibit “differences” that are “material” for purposes of the Internal Revenue Code. Because Cottage Savings received entitlements different from those it gave up, the exchange put both Cottage Savings and the Commissioner in a position to determine the change in the value of Cottage Savings’ mortgages relative to their tax bases. Thus, there is no reason not to treat the exchange of these interests as a realization event, regardless of the status of the mortgages under the criteria of Memorandum R-49.

Ill

Although the Court of Appeals found that Cottage Savings’ losses were realized, it disallowed them on the ground that they were not sustained under § 165(a) of the Code, 26 U. S. C. § 165(a). Section 165(a) states that a deduction shall be allowed for “any loss sustained during the taxable year and not compensated for by insurance or otherwise.” Under the Commissioner’s interpretation of § 165(a),

“To be allowable as a deduction under section 165(a), a loss must be evidenced by closed and completed transactions, fixed by identifiable events, and, except as otherwise provided in section 165(h) and §1.165-11, relating to disaster losses, actually sustained during the taxable year. Only a bona fide loss is allowable. Substance and not mere form shall govern in determining a deductible loss.” Treas. Reg. §1.165-l(b), 26 CFR §1.165-l(b) (1990).

The Commissioner offers a minimal defense of the Court of Appeals’ conclusion. The Commissioner contends that the losses were not sustained because they lacked “economic substance,” by which the Commissioner seems to mean that the losses were not bona fide. We say “seems” because the Commissioner states the position in one sentence in a footnote in his brief without offering further explanation. See Brief for Respondent 34-35, n. 39. The only authority the Commissioner cites for this argument is Higgins v. Smith, 308 U. S. 473 (1939). See Brief for United States in No. 89-1926, p. 16, n. 11.

In Higgins, we held that a taxpayer did not sustain a loss by selling securities below cost to a corporation in which he was the sole shareholder. We found that the losses were not bona fide because the transaction was not conducted at arm’s length and because the taxpayer retained the benefit of the securities through his wholly owned corporation. See Higgins v. Smith, supra, at 475-476. Because there is no contention that the transactions in this case were not conducted at arm’s length, or that Cottage Savings retained de facto ownership of the participation interests it traded to the four reciprocating S & L’s, Higgins is inapposite. In view of the Commissioner’s failure to advance any other arguments in support of the Court of Appeals’ ruling with respect to § 165(a), we conclude that, for purposes of this case, Cottage Savings sustained its losses within the meaning of § 165(a).

I — I

For the reasons set forth above, the judgment of the Court of Appeals is reversed, and the case is remanded for further proceedings consistent with this opinion.

So ordered.

Justice Blackmun,

with whom Justice White joins, concurring in part and dissenting in part in No. 89-1926, post, p. 573, and dissenting in No. 89-1965.

I agree that the early withdrawal penalties collected by Centennial Savings Bank FSB do not constitute “income by reason of the discharge ... of indebtedness of the taxpayer,” within the meaning of 26 U. S. C. § 108(a)(1) (1982 ed.), and that the penalty amounts are not excludable from Centennial's gross income. I therefore join Part III of the Court’s opinion in No. 89-1926.

I dissent, however, from the Court’s conclusions in these two cases that Centennial and Cottage Savings Association realized deductible losses for income tax purposes when each exchanged partial interests in one group of residential mortgage loans for partial interests in another like group of residential mortgage loans. I regard these losses as not recognizable for income tax purposes because the mortgage packages so exchanged were substantially identical and were not materially different.

The exchanges, as the Court acknowledges, were occasioned by Memorandum R-49, Record, Exh. 72-BT, issued by the Federal Home Loan Bank Board (FHLBB) on June 27, 1980, and by that Memorandum’s relaxation of theretofore-existing accounting regulations and requirements, a relaxation effected to avoid placement of “many S & L’s at risk of closure by the FHLBB” without substantially affecting the “economic position of the transacting S & L’s.” Ante, at 557. But the Memorandum, the Court notes, also had as a purpose the “facilit[ation of] transactions that would generate tax losses.” Ibid. I find it somewhat surprising that an agency not responsible for tax matters would presume to dictate what is or is not a deductible loss for federal income tax purposes. I had thought that that was something within the exclusive province of the Internal Revenue Service, subject to administrative and judicial review. Certainly, the FHLBB’s opinion in this respect is entitled to no deference whatsoever. See United States v. Stewart, 311 U. S. 60, 70 (1940); Graff v. Commissioner, 673 F. 2d 784, 786 (CA5 1982) (concurring opinion). The Commissioner, of course, took the opposing position. See Rev. Rul. 85-125, 1985-2 Cum. Bull. 180; Rev. Rul. 81-204, 1981-2 Cum. Bull. 157.

It long has been established that gain or loss in the value of property is taken into account for income tax purposes only if and when the gain or loss is “realized,” that is, when it is tied to a realization event, such as the sale, exchange, or other disposition of the property. Mere variation in value— the routine ups and downs of the marketplace — do not in themselves have income tax consequences. This is fundamental in income tax law.

In applying the realization requirement to an exchange, the properties involved must be materially different in kind or in extent. Treas. Reg. § 1.1001 — 1(a), 26 CFR §1.1001-1(a) (1990). This has been the rule recognized administratively at least since 1935, see Treas. Regs. 86, Art. 111-1, issued under the Revenue Act of 1934, and by judicial decision. See, e. g., Mutual Loan & Savings Co. v. Commissioner, 184 F. 2d 161 (CA5 1950). See also Mart v. United States, 268 U. S. 536, 541 (1925); Weiss v. Stearn, 265 U. S. 242, 254 (1924); United States v. Phellis, 257 U. S. 156 (1921). This makes economic as well as tax sense, for the parties obviously regard the exchanged properties as having equivalent values. In tax law, we should remember, substance rather than form determines tax consequences. Commissioner v. Court Holding Co., 324 U. S. 331, 334 (1945); Gregory v. Helvering, 293 U. S. 465, 469-470 (1935); Shoenberg v. Commissioner, 77 F. 2d 446, 449 (CA8), cert. denied, 296 U. S. 586 (1935). Thus, the resolution of the exchange issue in these cases turns on the “materially different” concept. The Court recognizes as much. Ante, at 559-560.

That the mortgage participation partial interests exchanged in these cases were “different” is not in dispute. The materiality prong is the focus. A material difference is one that has the capacity to influence a decision. See, e. g., Kungys v. United States, 485 U. S. 759, 770-771 (1988); Basic Inc. v. Levinson, 485 U. S. 224, 240 (1988); TSC Industries, Inc. v. Northway, Inc., 426 U. S. 438, 449 (1976).

The application of this standard leads, it seems to me, to only one answer — that the mortgage participation partial interests released were not materially different from the mortgage participation partial interests received. Memorandum R-49, as the Court notes, ante, at 557, n. 2, lists 10 factors that, when satisfied, as they were here, serve to classify the interests as “substantially identical.” These factors assure practical identity; surely, they then also assure that any difference cannot be of consequence. Indeed, nonmateriality is the full purpose of the Memorandum’s criteria. The “proof of the pudding” is in the fact of its complete accounting acceptability to the FHLBB. Indeed, as has been noted, it is difficult to reconcile substantial identity for financial accounting purposes with a material difference for tax accounting purposes. See First Federal Savings & Loan Assn. of Temple v. United States, 694 F. Supp. 230, 245 (WD Tex. 1988), aff’d, 887 F. 2d 593 (CA5 1989), cert. pending No. 89-1927. Common sense so dictates.

This should suffice and be the end of the analysis. Other facts, however, solidify the conclusion: The retention by the transferor of 10% interests, enabling it to keep on servicing its loans; the transferor’s continuing to collect the payments due from the borrowers so that, so far as the latter were concerned, it was business as usual, exactly as it had been; the obvious lack of concern or dependence of the transferor with the “differences” upon which the Court relies (as transferees, the taxpayers made no credit checks and no appraisals of collateral, see 890 F. 2d 848, 849 (CA6 1989)); 90 T. C. 372, 382 (1988); 682 F. Supp. 1389, 1392 (ND Tex. 1988); the selection of the loans by a computer programmed to match mortgages in accordance with the Memorandum R-49 criteria; the absence of even the names of the borrowers in the closing schedules attached to the agreements; Centennial’s receipt of loan files only six years after its exchange, id., at 1392, n. 5; the restriction of the interests exchanged to the same State; the identity of the respective face and fair market values; and the application by the parties of common discount factors to each side of the transaction — all reveal that any differences that might exist made no difference whatsoever and were not material. This demonstrates the real nature of the transactions, including nonmateriality of the claimed differences.

We should be dealing here with realities and not with superficial distinctions. As has been said many times, and as noted above, in income tax law we are to be concerned with substance and not with mere form. When we stray from that principle, the new precedent is likely to be a precarious beacon for the future.

I respectfully dissent on this issue.

       Congress abolished the FHLBB in 1989. See § 401 of the Financial Institutions Reform, Recovery, and Enforcement Act of 1989, Pub. L. 101-73, 103 Stat. 354.

       Memorandum R-49 listed 10 criteria for classifying mortgages as substantially identical.
      “The loans involved must:
      “1. involve single-family residential mortgages,
      “2. be of similar type (e. g., conventionals for conventionals),
      “3. have the same stated terms to maturity (e. g., 30 years),
      “4. have identical stated interest rates,
      “5. have similar seasoning (i. e., remaining terms to maturity),
      “6. have aggregate principal amounts within the lesser of 272% or $100,000 (plus or minus) on both sides of the transaction, with any additional consideration being paid in cash,
      “7. be sold without recourse,
      “8. have similar fair market values,
      “9. have similar loan-to-value ratios at the time of the reciprocal sale, and
      “10. have all security properties for both sides of the transaction in the same state.” Record, Exh. 72-BT.

       By exchanging merely participation interests rather than the loans themselves, each party retained its relationship with the individual obli-gors. Consequently, each S & L continued to service the loans on which it had transferred the participation interests and made monthly payments to the participation-interest holders. See 90 T. C. 372, 381 (1988).

       The two other Courts of Appeals that have considered the tax treatment of Memorandum R-49 transactions have found that these transactions do give rise to deductible losses. See Federal Nat. Mortgage Assn.
        v. Commissioner, 283 U. S. App. D. C. 53, 56-58, 896 F. 2d 580, 583-584 (1990); San Antonio Savings Assn. v. Commissioner, 887 F. 2d 577 (CA5 1989).

       Section 202(a) of the 1924 Act provided:
      “Except as hereinafter provided in this section, the gain from the sale or other disposition of property shall be the excess of the amount realized therefrom over the basis provided in subdivision (a) or (b) of section 204, and the loss shall be the excess of such basis over the amount realized.” The essence of this provision was reenacted in § 111(a) of Revenue Act of 1934, eh. 277, 48 Stat. 703; and then in § 111(a) of the Internal Revenue Code of 1939, ch. 1, 53 Stat. 37; and finally in § 1001(a) of the Internal Revenue Code of 1954, Pub. L. 591, 68A Stat. 295.

       What is now Treas. Reg. § 1.1001-1 originated as Treas. Reg. 86, Art. 111-1, which was promulgated pursuant to the Revenue Act of 1934. That regulation provided:
      “Except as otherwise provided, the Act regards as income or as loss sustained, the gain or loss realized from the conversion of property into cash, or from the exchange of property for other property differing materially either in kind or in extent” (emphasis added).

       In its brief in United States v. Centennial Savings Bank FSB, No. 89-1926, the United States cites two Revenue Rulings that support the position that mortgages exchanged through reciprocal mortgage sales are not materially different. See Brief for United States 25, n. 21 (citing Rev. Rul. 85-125, 1985-2 Cum. Bull. 180; Rev. Rui. 81-204, 1981-2 Cum. Bull. 157). Perhaps because the two Revenue Rulings postdate the reciprocal mortgage exchange transaction at issue here and do not purport to define the “differ materially” language in Treasury Regulation §1.1001-1, the Commissioner has not argued that the position taken in these rulings is entitled to deference. Compare, e. g., National Muffler Dealers Assn., Inc. v. United States, 440 U. S. 472, 483-484, and nn. 16-19 (1979) (deferring to position reflected in longstanding series of Revenue Rulings consistently adhering to same position in a variety of fact patterns). See generally Udall v. Tallman, 380 U. S. 1, 16-17 (1965) (agency’s reasonable interpretation of its own regulations is entitled to deference).


text:
    UNITED STATES v. CENTENNIAL SAVINGS BANK FSB (RESOLUTION TRUST CORPORATION, RECEIVER)
    No. 89-1926.
    Argued January 15, 1991
    Decided April 17, 1991

      Marshall, J., delivered the opinion of the Court, in which Rehnquist, C. J., and Stevens, O’Connor, Scalia, Kennedy, and Souter, JJ., joined, in Parts I’and III of which White, J., joined, and in Part III of which Blackmun, J., joined. Blackmun, J., filed an opinion concurring in part and dissenting in part, in which White, J., joined, ante, p. 568.

      Acting Solicitor General Roberts argued the cause for the United States. With him on the briefs were Assistant Attorney General Peterson, Deputy Solicitor General Wallace, Clifford M. Sloan, Richard Farber, and Bruce R. Ellisen.

      Michael F. Duhl argued the cause for respondent. With him on the brief were Mark L. Perlis, Frederic W. Hickman, Alfred J. T. Byrne, Colleen B. Bombardier, and Daniel R. Richards.

      Briefs of amici curiae urging affirmance were filed for the Federal National Mortgage Association by Joseph Angland, Felix B. Laughlin, David C. Garlock, Richard F. Neel, Jr., Caryl S. Bernstein, Carolyn J. A. Swift, and Michel A. Daze; for Main Line Federal Savings Bank et al. by Zachary P. Alexander; and for the United States League of Savings Institutions by Richard L. Bacon.

   Justice Marshall

delivered the opinion of the Court.

In this case, we consider two questions relating to the federal income tax liability of respondent Centennial Savings Bank FSB (Centennial). The first is whether Centennial realized deductible losses when it exchanged its interests in one group of residential mortgage loans for another lender’s interests in a different group of residential mortgage loans. The second is whether penalties collected by Centennial for the premature withdrawal of federally insured certificates of deposit (CD’s) constituted “income by reason of the discharge . . . of indebtedness” excludable from gross income under 26 U. S. C. § 108(a)(1)(C) (1982 ed.). The Court of Appeals answered both questions affirmatively. We agree with the Court of Appeals that Centennial’s mortgage exchange gave rise to an immediately deductible loss, but we reverse the Court of Appeals’ determination that Centennial was entitled to exclude from its taxable income the early withdrawal penalties collected from its depositors.

I

Centennial is a mutual savings and loan institution (S & L) formerly regulated by the Federal Home Loan Bank Board (FHLBB). At issue in this case are two sets of transactions involving Centennial in the 1981 tax year.

The first was Centennial’s exchange of “90% participation interests” in a set of mortgage loans held by Centennial for “90% participation interests” in a different set of mortgage loans held by the Federal National. Mortgage Association (FNMA). Secured by residential properties located primarily in northern Texas, Centennial’s 420 loans had a face value of approximately $8.5 million and a fair market value of approximately $5.7 million; FNMA’s 377 loans, secured by properties located throughout Texas, likewise had a face value of approximately $8.5 million and a fair market value of $5.7 million. Centennial and FNMA structured the exchange so that the respective mortgage packages would be deemed “substantially identical” under the FHLBB’s Memorandum R-49, dated June 27, 1980, a regulatory directive aimed at identifying mortgage exchanges that would not generate accounting losses for FHLBB regulatory purposes but that would generate deductible losses for federal tax purposes. See generally Cottage Savings Assn. v. Commissioner, ante, at 556-557. On its 1981 return, Centennial claimed a deduction for the loss of $2,819,218, the difference between the face value (and cost basis) of the mortgage interests surrendered to FNMA and the market value of the mortgage interests received from FNMA in return.

The second set of transactions was Centennial’s collection of early withdrawal penalties from customers who prematurely terminated their CD accounts. Each CD agreement established a fixed-term, fixed-interest account. See App. 27-29. Consistent with federal regulations, each agreement also provided that the depositor would be required to pay a penalty to Centennial should the depositor withdraw the principal before maturity. See 12 CFR § 526.7(a) (1979); 12 CFR § 526.7(a) (1980); 12 CFR §1204.103 (1981). Thus, in the event of premature withdrawal, the depositor was entitled under the CD agreement to the principal and accrued interest, minus the applicable penalty. See App. 27-29.

Centennial collected $258,019 in early withdrawal penalties in 1981. In its tax return for that year, Centennial treated the penalties as income from the discharge of indebtedness. Pursuant to 26 U. S. C. §§108 and 1017 (1982 ed.), Centennial excluded the $258,019 from its income and reduced the basis of its depreciable property by that amount.

On audit, the Internal Revenue Service disallowed the deduction of the losses associated with Centennial’s mortgages, and determined that Centennial should have declared as income the early withdrawal penalties collected that year. After paying the resulting deficiencies, Centennial instituted this refund action in the District Court for the Northern District of Texas, which entered judgment for the United States on the mortgage-exchange issue, and for Centennial on the early withdrawal penalty issue. 682 F. Supp. 1389 (1988).

The Court of Appeals for the Fifth Circuit reversed in part and affirmed in part. 887 F. 2d 595 (1989). It reversed the District Court’s ruling that Centennial did not realize a deductible loss in the mortgage-exchange transaction. Relying on its reasoning in another decision handed down the same day, see San Antonio Savings Assn. v. Commissioner, 887 F. 2d 577 (1989), the Court of Appeals concluded that although the respective mortgage packages exchanged by Centennial and FNMA were “substantially identical” under Memorandum R-49, the two sets of mortgages were nonetheless “materially different” for tax purposes because they were secured by different residential properties. See 887 F. 2d, at 600. Consequently, the court held, the exchange of the two sets of mortgages did give rise to a realization event for tax purposes, allowing Centennial immediately to recognize its losses. See ibid.

The Court of Appeals affirmed the District Court’s conclusion that Centennial was entitled to treat the early withdrawal penalties as income from the discharge of indebtedness under § 108. The court reasoned that “the characterization of income as income from the discharge of indebtedness depends purely on the spread between the amount received by the debtor and the amount paid by him to satisfy his obligation.” Id., at 601. Under this test, the early withdrawal penalties constituted income from the discharge of indebtedness, the court concluded, because the penalties reduced the size of Centennial’s obligation to its depositors. See id., at 601-602. The court rejected the United States’ characterization of the penalties as merely a “medium of payment” for Centennial’s performance of its “separate obligation” to release the deposits prior to maturity. Id., at 604-606.

The United States thereafter petitioned this Court for a writ of certiorari. Because the Court of Appeals’ dispositions of both the mortgage-exchange issue and the early withdrawal penalty issue are in conflict with decisions in other Circuits, and because of the importance of both issues for the savings and loan industry, we granted the petition. 498 U. S. 808 (1990).

II

The question whether Centennial realized tax-deductible losses when it exchanged mortgage interests with FNMA is controlled by our decision in Cottage Savings Assn. v. Commissioner. In Cottage Savings, we recognized that a property exchange gives rise to a realization event for purposes of § 1001(a) of the Internal Revenue Code so long as the exchanged properties are “materially different.” Ante, at 560-562. We concluded that the properties are “different” in the sense “material” to the Code so long as they embody legally distinct entitlements. Ante, at 564-565.

That test is easily satisfied here. As in Cottage Savings, the participation interests exchanged here were in loans made to different obligors and secured by different properties. Thus, the interests embodied distinct entitlements. We therefore affirm the Court of Appeals’ conclusion that Centennial was entitled to a refund of the disallowed losses claimed on its mortgages.

Ill

We next consider the question whether the early withdrawal penalties collected by Centennial constituted “income by reason of the discharge ... of indebtedness” excludable from income under 26 U. S. C. § 108(a)(1) (1982 ed.). We conclude that the penalties were not subject to exclusion under §108 because the depositors who paid these penalties did not “discharge” Centennial from any repayment obligation.

The version of § 108 in effect for the 1981 tax year states:

“Gross income does not include any amount which (but for this subsection) would be includible in gross income by reason of the discharge (in whole or in part) of indebtedness of the taxpayer if—
“(C) the indebtedness discharged is qualified business indebtedness.” 26 U. S. C. § 108(a)(1) (1982 ed.).

“[Qjualified business indebtedness” includes “indebtedness . . . incurred or assumed ... by a corporation.” 26 U. S. C. § 108(d)(4)(A) (1982 ed.). Income from the discharge of qualified business indebtedness can be excluded from gross income under § 108 only if the taxpayer elects to reduce the basis of his depreciable property by an amount equal to the income excluded. 26 U. S. C. §§ 108(c)(1), 108(d)(4)(B), 1017 (1982 ed.). Thus, the effect of § 108 is not genuinely to exempt such income from taxation, but rather to defer the payment of the tax by reducing the taxpayer’s annual depreciation deductions or by increasing the size of taxable gains upon ultimate disposition of the reduced-basis property.

In characterizing early withdrawal penalties as discharge-of-indebtedness income, Centennial, like the Court of Appeals, focuses purely on the “spread” between the debt that Centennial assumed upon the opening of each CD account and the amount that it actually paid each depositor upon the closing of the account. See 887 F. 2d, at 601. When a depositor opens a CD account, Centennial notes, the bank becomes indebted to the depositor for the principal of the deposit plus accrued interest. By virtue of its collection of an early withdrawal penalty, however, the bank satisfies the debt for less than that amount should the depositor withdraw the principal before maturity. The end result, in Centennial’s view, is no different from what it would have been had the bank and depositor (freed from the restraints of bank regulatory law) formed no agreement on an early withdrawal penalty at the outset but rather negotiated a forgiveness of that amount at the time of withdrawal.

We reject this analysis because it fails to make sense of §108’s use of the term “discharge.” As used in §108, the term “discharge . . . of indebtedness” conveys forgiveness of, or release from, an obligation to repay. A depositor who prematurely closes his account and pays the early withdrawal penalty does not forgive or release any repayment obligation on the part of the financial institution. The CD agreement itself provides that the depositor will be entitled only to the principal and accrued interest, less the applicable penalty, should the depositor prematurely withdraw the principal. Through this formula, the depositor and the bank have determined in advance precisely how much the depositor will be entitled to receive should the depositor close the account on any day up to the maturity date. Thus, the depositor does not “discharge” the bank from an obligation when it accepts an amount equal to the principal and accrued interest minus the penalty, for this is exactly what the bank is obligated to pay under the terms of the CD agreement.

Because § 108 presupposes the “discharge” of an obligation to repay, we disagree with Centennial and the Court of Appeals’ conclusion that the “spread” between the debt assumed by Centennial and the amount paid by Centennial upon the closing of the account is sufficient to trigger § 108. The existence of such a spread is sufficient to demonstrate that Centennial enjoyed an accession to income equal in size to the amount of the penalty. But because this income was not the product of the release of any obligation assumed by Centennial at the outset of the bank-depositor relationship, it does not constitute income “by reason of [a] discharge.” In sum, to determine whether the debtor has realized “income by reason of the discharge ... of indebtedness,” it is necessary to look at both the end result of the transaction and the repayment terms agreed to by the parties at the outset of the debtor-creditor relationship.

This common-sense reading of the statutory language best comports with the purpose underlying § 108. The tax-deferral mechanism in § 108 is designed to mitigate the effect of treating the discharge of indebtedness as income. See 26 U. S. C. §61(a)(12) (1982 ed.) (“gross income . . . includes] . . . [i]ncome from discharge of indebtedness”). Borrowed funds are excluded from income in the first instance because the taxpayer’s obligation to repay the funds offsets any increase in the taxpayer’s assets; if the taxpayer is thereafter released from his obligation to repay, the taxpayer enjoys a net increase in assets equal to the forgiven portion of the debt, and the basis for the original exclusion thus evaporates. See United States v. Kirby Lumber Co., 284 U. S. 1, 3 (1931); Commissioner v. Jacobson, 336 U. S. 28, 38 (1949); see also Commissioner v. Tufts, 461 U. S. 300, 307, 310-311, n. 11 (1983). But while the cancellation of the obligation to repay increases the taxpayer’s assets, it does not necessarily generate cash with which the taxpayer can pay the resulting income tax. Congress established the tax-deferral mechanism in § 108 so that the prospect of immediate tax liability would not discourage businesses from taking advantage of opportunities to repurchase or liquidate their debts at less than face value. See H. R. Rep. No. 855, 76th Cong., 1st Sess., 5 (1939); S. Rep. No. 1631, 77th Cong., 2d Sess., 77-78 (1942). See generally Wright, Realization of Income Through Cancellations, Modifications, and Bargain Purchases of Indebtedness: I, 49 Mich. L. Rev. 459, 477, 492 (1951).

This rationale is squarely implicated only when the debtor is seeking forgiveness or cancellation of a pre-existing repayment obligation. A debtor who negotiates in advance the circumstances in which he will liquidate the debt for less than its face value is in a position to anticipate his need for cash with which to pay the resulting income tax and can negotiate the terms of the anticipated liquidation accordingly. Moreover, insofar as the CD agreements at issue in this case committed Centennial to releasing the deposits at the sole election of the depositors, Centennial abandoned any control whatsoever over whether and when these particular debt obligations would be liquidated. Consequently, unlike a debtor considering the negotiation of an adjustment of the terms of his duty to repay, Centennial had no discretion to take the tax effects of the transaction into account before liquidating its debt obligations at less than face value.

It is true, as Centennial points out, that construing § 108 to apply only to debt reductions stemming from a negotiated forgiveness of a duty to repay withholds a tax incentive to include “anticipatory discharge” terms in the credit agreement at the outset. But we read the statutory language as embodying a legislative choice not to extend the benefits of § 108’s deferral mechanism that far. For the reasons that we have stated, Congress could easily have concluded that only debtors seeking a release from a pre-existing repayment obligation need or deserve the tax break conferred by § 108. Consistent with the rule that tax-exemption and -deferral provisions are to be construed narrowly, Commissioner v. Jacobson, supra, at 49; Elam v. Commissioner, 477 F. 2d 1333, 1335 (CA6 1973), we conclude that Congress did not intend to extend the benefits of §108 beyond the setting in which a creditor agrees to release a debtor from an obligation assumed at the outset of the relationship.

>

For the foregoing reasons, the judgment of the Court of Appeals is affirmed in part and reversed in part, and the case is remanded for further proceedings consistent with this opinion.

It is so ordered.

For opinion of Justice Blackmun, concurring in part and dissenting in part, see ante, p. 568.

       Justice White joins Parts I and III of this opinion, and Justice Blackmun joins Part III.

       While this case was pending on appeal, the FHLBB found Centennial to be insolvent. Centennial is currently under the receivership of the Resolution Trust Corporation.

       By exchanging merely participation interests, each party retained its relationships with the obligors of the exchanged loans. See Cottage Savings Assn. v. Commissioner, ante, at 557-558, n. 3.

       The Fifth Circuit’s conclusion that an exchange of mortgages that are “substantially identical” under Memorandum R-49 can give rise to realizable tax losses is in conflict with a decision of the Sixth Circuit. See Cottage Savings Assn. v. Commissioner, 890 F. 2d 848 (1989), rev’d and remanded, ante, p. 554. The Fifth Circuit’s conclusion that early withdrawal penalties constitute discharge-from-indebtedness income under the pre-1986 version of § 108 is in conflict with a decision of the Seventh Circuit. See Colonial Savings Assn. v. Commissioner, 854 F. 2d 1001 (1988), cert. denied, 489 U. S. 1090 (1989). In 1986, Congress amended § 108, limiting its application to situations in which the taxpayer is insolvent or in bankruptcy at the time of the discharge of his indebtedness. See Pub. L. 99-514, § 822(a), 100 Stat. 2373; see also Pub. L. 100-647, § 1004(a)(1), 102 Stat. 3385 (1988) (extending §108 to “qualified-farm indebtedness”). We granted certiorari nonetheless in light of the significant number of pending cases concerning the tax status of early withdrawal penalties collected prior to 1986.

       “The gain from the sale or other disposition of property shall be the excess of the amount realized therefrom over the adjusted basis provided in section 1011 for determining gain, and the loss shall be the excess of the adjusted basis provided in such section for determining loss over the amount realized.” 26 U. S. C. § 1001(a).

       It also includes “indebtedness . . . incurred or assumed ... by an individual in connection with property used in his trade or business.” 26 U. S. C. § 108(d)(4)(A) (1982 ed.).

       “Discharge” can be used to signify various means of extinguishing a legal duty. See generally Black’s Law Dictionary 463 (6th ed. 1990). Thus, a debtor might be said to “discharge” his debt by satisfying it. But § 108 uses “income by reason of the discharge ... of indebtedness” to refer to the change in the debtor’s financial condition when the debtor is no longer legally required to satisfy his debt either in part or in full. “Discharge” in this sense can occur only if the creditor cancels or forgives a repayment obligation.

       Renewing the argument that it unsuccessfully advanced in the Court of Appeals, the United States characterizes the penalties not as income by reason of the discharge of indebtedness, but rather as income for Centennial’s performance of a “separate obligation.” This argument draws on authorities recognizing that § 108 does not apply when a creditor discharges a debtor’s obligation in exchange for services or some other form of nonmonetary consideration. See Spartan Petroleum Co. v. United States, 437 F. Supp. 733 (SC 1977) (debt discharged in exchange for cancellation of distributorship agreement); OKC Corp. v. Commissioner, 82 T. C. 638, 649-650 (1984) (debt discharged in exchange for settlement of lawsuit). In that situation, the debt is not forgiven but is in fact satisfied in full through the debtor’s performance of a “separate obligation”; discharge of the debt is merely the “medium of payment” for that performance, and must be treated as ordinary income for tax purposes. See S. Rep. No. 96-1035, p. 8, n. 6 (1980) (“Debt discharge that is only a medium for some other form of payment, such as a gift or salary, is treated as that form of payment rather than under the debt discharge rules”). See generally 1 B. Bittker & L. Lokken, Federal Taxation of Income, Estates and Gifts ¶ 6.4.7, p. 6-66 (2d ed. 1989). Because we conclude that Centennial’s reliance on § 108 fails for a more fundamental reason — the absence of a “discharge” for purposes of the statute — we need not consider whether the early withdrawal penalties were actually payments for services unrelated to the debtor-creditor relationship.