Claridge Apartments Company v. Commissioner of Internal Revenue/Opinion of the Court

The issues arise out of deficiency assessments made in respect to petitioner's federal income and excess profits taxes for the years 1935 to 1938 inclusive. They involve the applicability of Section 270 of the Bankruptcy Act, as amended, so as to require reduction of depreciation allowances claimed.

The transactions arose in connection with a reorganization proceeding under Section 77B, 48 Stat. 912, 11 U.S.C.A. § 207. They consisted essentially of petitioner's acquisition of all the assets of the insolvent debtor corporation, by an exchange of its capital stock, without pay value for the latter's bonds then outstanding. The Commissioner contends that the exchange resulted in a cancellation or reduction of indebtedness within the meaning of Section 270, so as to require a corresponding reduction in the basis of the property transferred. Accordingly he now urges that the assessment should be made, as the section requires, upon the basis of the fair market value of the property. The taxpayer's claim is made on the higher basis of the debtor corporation, in the view that Section 270 is not applicable to such a transaction.

This difference has been the basic one between the parties in proceedings before the Tax Court, the Circuit Court of Appeals and here. Others include a similar question with respect to the extinction of the debtor's liability for the accrued unpaid interest on the bonds and whether Section 270 is made applicable retroactively to the years prior to 1938, by virtue of the provisions of Section 276, sub. c(3) of the Chandler Act, 11 U.S.C.A. § 676, sub. c(3).

The Tax Court decided the principal issue on the merits in favor of the taxpayer, except with respect to the accrued interest. Cf. also Capento Securities Corp. v. Commissioner, 47 B.T.A. 691, affirmed, 140 F.2d 382. It likewise limited the application of Section 270 to the year 1938 and succeeding years. 1 T.C. 163. The Court of Appeals reversed the Tax Court's decision in both respects, holding there was a cancellation of indebtedness with respect to the unpaid principal and that Section 270 was applicable retroactively to require the prescribed reduction in basis for each of the tax years in question. 138 F.2d 962. Certiorari was granted, 321 U.S. 759, 64 S.Ct. 788, because of the importance of the questions presented and a conflict on the question of retroactivity. The facts are stated shortly in the margin, to give concrete perspective.

Petitioner earnestly argues that the Tax Court's decision, so far as this was in its favor, should be affirmed on the authority of Dobson v. Commissioner, 320 U.S. 489, 64 S.Ct. 239, though in other respects it seeks a reversal of that court's judgment. For reasons presently to be stated, we think the case must be disposed of in its entirety by the application of Section 276, sub. c(3), which determines the extent to which Sections 268 and 270 are applicable in point of time. Accordingly, we are not required to pass upon the merits of the other interesting issues or whether they fall within the Dobson admonition. On the other hand, the question of the applicability of Sections 268 and 270, under the terms of Section 276, sub. c(3), to the transactions involved in this case obviously is one of law and of a sort not requiring the specialized experience of the Tax Court to determine. Furthermore, it involves making an accommodation between the conflicting policies, in part, of the bankruptcy laws and the revenue enactments. Sections 268 and 270 are integral parts of the former, though related in subject matter to the latter, and were so placed for purposes relevant primarily to that legislation. For these reasons the issue falls beyond the scope of the Dobson case.

The question presented by Section 276, sub. c(3) must be determined in the light of the problem created by Sections 268 and 270. A statement of their history is necessary to a general understanding of that problem. It stems basically from United States v. Kirby Lumber Co., 284 U.S. 1, 52 S.Ct. 4, 76 L.Ed. 131, and subsequent decisions which have applied the principle of that case. By them a corporation may realize income from the cancellation or reduction of indebtedness, depending upon the circumstances in which the transaction occurs. However, the line between income producing reductions and others is not precise or definite and great uncertainty prevailed concerning it, both in 1934 when Section 77B was enacted and in 1938 when Chapter X of the Chandler Act was adopted, 11 U.S.C.A. § 501 et seq. The uncertainty was greatest perhaps in relation to transactions occurring in the course of insolvent reorganizations.

Some of the obscurity has been created by the very legislation enacted to remove it. This has been true of the successive 'reorganization' provisions, including those for 'nonrecognition' and for transfer of 'basis,' which have appeared in the various revenue acts from 1918 (cf. 40 Stat. 1057) forward. Closely related, as these have been, to the problem whether income is realized by the cancellation or reduction of indebtedness in connection with a reorganization, they have tended to obscure if not to blot out that problem altogether in situations covered by their terms.

By and large the provisions are the product of and have reflected efforts at compromise, none too successful, between the conflicting pulls of policy involved in the revenue acts and in the bankruptcy legislation. They were drawn and enacted however as parts of the revenue laws and have reflected increasingly the policy of that legislation. Accordingly, the succession of statutes relating to this field, prior to Sections 268 and 270, represents a series of shifts in the legislative pendulum from initial broad tax relief, to encourage needed reorganizations, toward narrowed exemption, in order to discourage use of reorganization for evasion of taxes. The general purpose of the provisions, however, was to postpone the tax consequences which otherwise might ensue upon transactions occurring in such circumstances that immediate imposition was regarded as economically unjustifiable. This continued in the 1934 general revision, which remained in effect during the period of this litigation.

In some respects, as compared with the preexisting legislation, the 1934 provisions broadened, but in others they restricted the scope of application of the principles of nonrecognition and transfer of basis. Nevertheless, they were applicable to all exchanges falling within their terms, whether or not the plan was executed in connection with a judicial proceeding. Consequently, when in June, 1934, Section 77B was adopted, the 1934 revenue provisions became applicable to reorganizations under that section, but only if they met the tests prescribed in the revenue acts, including such judicially interpolated matters as 'continuity of interest' and 'business purpose.' Many 77B reorganizations did not qualify under these tests or on substantial grounds were thought not to do so.

The consequence was seriously to clog the use of the 77B procedure. Obstacles were imposed not only by the differences in the two statutory definitions of 'reorganization,' but also by ambiguities in each definition which in themselves created considerable areas of uncertainty. And underlying these remained the mystery of when income would be regarded as realized, which continued to haunt reorganizers unsure of whether they could bring themselves within the statutory exemptions. In short, the necessity of squaring the reorganization first with Section 77B, then with the different terms of the revenue provisions, and the uncertainties involved under each statute in doing this, added to the puzzle of 'realized income,' made the process of creditors' reorganization under the former act a highly dubious adventure. To an undetermined extent the effect of the revenue act's provisions was to nullify or make impossible of realization the objects of Section 77B.

In this setting Congress adopted the Chandler Act in 1938. That statute was a general revision of the provisions for bankruptcy reorganization, including those previously made under Section 77B. One of its principal objects was to encourage the freer use of bankruptcy reorganization in order to avoid unnecessary or premature liquidations. By this time Congress had become aware of the hazardous and hampering effects of the 1934 revenue provisions upon the operation of bankruptcy reorganizations under Section 77B. The objectives of the Chandler Act, in similar situations, could not be achieved without removal of these impediments. Some provision was essential to prevent them from having the same effects upon the working of the new legislation. Accordingly Section 268 was devised for this purpose and became a part of the Chandler Act itself. It had no other object, and there was no other occasion for its being, than to free Chapter X reorganizations from the tax deterrents, including tax uncertainties, imposed by the existing revenue act provisions.

The relieving effect of Section 268 was confined in three ways, namely, (1) to transactions occurring in a Chapter X reorganization; (2) to transactions involving a modification or a cancellation, in whole or in part, of the debtor's indebtedness; and (3) its benefits were limited to the debtor corporation, the trustee, if any, provided for in the plan, and the successor or transferee corporation. Within these limitations the section provided that 'no income or profit, taxable under any law * *  * shall *  *  * be deemed to have accrued to or to have been realized by *  *  * ' the parties specified, and thus removed Chapter X transactions from incidence of the uncertainties characterizing the general 'reorganization' provisions. One who followed the procedure could be assured he would not thereby run into tax consequences which would be worse than the economic illness requiring that cure.

As it was originally considered by the House Committee, the Chandler Act contained no counterpart of the present Section 270. Had Section 268 thus been left to stand alone, with no accompanying provision for 'basis,' either there would have been no applicable provision for 'basis' or the general 'basis' provisions would have remained applicable to Chapter X reorganizations falling within their terms, with the result that they would apply to some Chapter X reorganizations but not to others. The latter view apparently was generally accepted. Under it much of the previous uncertainty would have remained, but with its focus shifted from 'realized income' to 'basis.' Moreover, it was the view of Treasury officials, apparently in the assumption of continued transfer of 'basis' under the general provisions, that the effect of Section 268 would be to provide a double deduction in some cases, unless complemented by a corresponding 'basis' provision, and thus be unfair to the revenue.

Accordingly the Treasury, and others, made various proposals, which eventuated in the adoption of Section 270 in its original form. This provided for transfer of basis, as did the code provisions, but required that it be decreased by the amount of the reduction of indebtedness, a measure at variance with the terms of the code. It was from the requirement of reduction, and the measure provided for it, that new difficulties were derived. Although the only occasion for making a further provision concerning basis arose from the adoption of Section 268 and although the legislative history discloses the purpose of Congress exactly contrary to placing Chapter X reorganizations at radical disadvantage from others, the literal effect of the original Section 270 came near if not entirely to wiping out the whole benefit conferred by Section 268. Soon it was realized that literal application of the specified new measure of reduction would require decrease of basis in many instances to zero or even to a point below zero, because the amount of the debt cancelled or reduced would equal or exceed the value of the property or that assigned to the basis transferred. Thus, any tax benefit derived from Section 268, in such cases, would be more than offset by the higher taxes resulting in later years from the absence of any depreciation base and in case of sale of the property acquired. And in cases where no benefit could be derived from Section 268, the effect of applying Section 270 was, if not to impose a capital levy, then to deny the new owners equal treatment, not only with other transferees under the code provisions, but with all other taxpayers.

Congress, in view of its original object in adopting Section 268, could not possibly have intended such consequences for Section 270. The cure was worse than the disease. The legislative history gives the clear impression that adoption of the original Section 270 was a plain blunder, the consequences of which were not foreseen, understood or intended by those who finally gave it the form of law.

Legislative relief obviously was in order and was forthcoming at the next session of Congress, in the amendment of Section 270 adding the language giving it its present form. The amendment removed some, but not all of the uncertainty confronting Chapter X reorganizers. It placed a floor to the amount of reduction required. In no case would basis be reduced below fair market value. But this was only partial cure of the original infirmities. Above the floor, debt cancellation remained the measure of reduction, thus keeping Chapter X reorganizations generally at a disadvantage with those taking place under the code. But, what was more important, the chief hazard remained, namely, whether Section 270 was intended to operate only where Section 268 was effective to afford actual tax benefit or, as the Government contends, regardless of whether such relief was afforded. And in this case the hazard has been realized in assessment.

With this background we turn to Section 276, sub. c(3). By their own terms Sections 268 and 270 apply only to transactions arising in connection with proceedings 'under this chapter,' that is, Chapter X of the Chandler Act. The instant transactions arose in proceedings, not under Chapter X, but under Section 77B, which had been closed by final decree March 1, 1937. The Chandler Act became effective September 22, 1938. Accordingly, Sections 268 and 270, of their own force, are not applicable to these transactions. If they are so at all it is by virtue of Section 276, sub. c(3), which the Government says must be construed to extend their operation retroactively to include these facts. This petitioner disputes.

The language immediately in question is the italicized part of subdivision (3), as follows:

'c. the provisions of sections 77A and 77B * *  * shall continue in full force and effect with respect to proceedings pending *  *  * upon the effective date of this amendatory Act, except that-

'(3) sections 268 and 270 of this Act shall apply to any plan confirmed under section 77B before the effective date of this ammendatory Act and to any plan which may be confirmed under section 77B on and after such effective date, except that the exemption provided by section 268 of this Act may be disallowed if it shall be made to appear that any such plan had for one of its principal purposes the avoidance of income taxes, and except further that where such plan has not been confirmed on and after such effective date, section 269 of this Act shall apply where practicable and expedient.' (Emphasis added.) 52 Stat. 905, 11 U.S.C.A. § 676, 11 U.S.C.A. § 676.

Three constructions have been advanced. Shortly stated they are that Sections 268 and 270 apply to transactions involved in 77B proceedings (1) only if the proceedings were pending September 22, 1938; (2) only for 1938 and later tax years, but including transactions in proceedings closed before September 22, 1938; (3) for all tax years from 1934 forward as to transactions in all proceedings in which a plan had been or should be confirmed, regardless of whether the proceedings were pending or had been closed on September 22, 1938.

The petitioner advances the first two views, alternatively; the Government the third. The Government interprets the italicized language as if it were wholly disconnected from and unrelated to the preceding portions of Section 276, sub. c, in other words, as an entirely independent provision unlimited by its statutory context. Petitioner, on the other hand, regards it as merely a part or phase of Section 276, sub. c, and thus reaches the exactly contrary view of its meaning. The statute, it says, refers in the first paragraph of 'c' to 'proceedings pending' under 77B and, to quote the brief, 'exceptions (1), (2) and (3) are keyed into this first paragraph and refer to pending proceedings also. They merely except from the pending cases those to which 77B is not to apply. Since sub. c deals only with pending cases and not closed cases, they refer also to pending cases.' The Government concedes there is force in this view, though it suggests, we think untenably, that the question is doubtfully open. The Court of Appeals accepted the Government's view, the Tax Court the alternative or second view advanced by the taxpayer. We think neither can be accepted and that the effect of Section 276, sub. c(3) is to confine the application of Sections 268 and 270, in 77B proceedings, to proceedings pending when the Chandler Act became effective.

If Sections 268 and 270 were to be applied to all reorganizations completed under Section 77B, literally they would cover all such transactions running back to 1934, when the latter section was enacted. As to proceedings closed when the Chandler Act took effect, this would involve disturbance of tax consequences already settled for five years, unless cases are excepted where the statute of limitations had run. We have no means of knowing how much resurrection of old claims or generation of new ones in respect to settled matters this would create. Nor did the authors of the Chandler Act. But, from the circumstances of the time and the very necessities which brought about adoption of Section 77B, the volume must have been considerable.

To construe Section 276, sub. c(3) to produce such consequences in no way would further the primary objects of Sections 268 and 270, which were to encourage use of Chandler Act procedures, at the same time preventing their abuse for tax advantage. Rather it would pervert those sections by changing their character, to the extent of their retroactive operation, from relief provisions to purely revenue measures of the worst type. In adopting them Congress was not uprooting the whole tax past of reorganized debtors and their creditors. It was, or purported to be, giving relief from harsh or uncertain tax consequences to persons reorganizing presently or in the future.

The language does not require such unlimited construction. The words are not directed expressly to past tax years. Nor are they focused upon transactions in closed proceedings. It is true that Section 276, sub. c(3), if construed as though it were entirely independent of the remainder of Section 276, sub. c, does not refer explicitly to pending 77B proceedings, except in its concluding clause. Yet it is part and parcel of that section, which in all other respects deals only with pending and future proceedings, not with closed ones. And the concluding clauses of (3) afford additional evidence that it was intended to apply only to plans confirmed or to be confirmed in pending proceedings, as does also its setting in the context of Section 276 as a whole.

Thus Section 276, in subsections a, b and c (excepting only Section 276, sub. c(3)), deals exclusively with pending or future proceedings. Congress' concern in 'a' was that Chapter X should apply notwithstanding the substantive rights of debtors, creditors and others had arisen before the effective date of the Act. In 'b' it was that the pendency of bankruptcy and receivership proceedings should not defeat resort to the Chandler Act's provisions; in 'c' it was with an accommodation of the provisions of Sections 77A and 77B and those of the Chandler Act as to pending proceedings. Apart from Section 276, sub. c(3), therefore, the whole problem treated in Section 276 was to give the Chandler Act as wide room as possible for future operation, notwithstanding the previous vesting of substantive rights or institution of bankruptcy or reorganization proceeding. Congress was concerned with the Act's future operation, as a remedial provision, not as a method of creating new and retroactive substantive rights and liabilities.

This being true, it is difficult to understand why Congress might wish to follow exactly the opposite policy with reference to newly created substantive tax rights and liabilities. It would seem wholly incongruous to imply such a purpose in the absence of language unquestionably requiring it, both as a matter of general legislative policy and, more especially, as one of accommodation with the purposes of the particular legislation. In short, apart from subdivision (3), relating to tax incidents of reorganization, all of Section 276 was devoted entirely to matters affecting pending and future proceedings. We can find reason for no other view than that this was true also of the provisions for application of the new tax features.

This is borne out by the concluding clauses of Section 276, sub. c(3) itself, which provide for exceptions to its operation. The second exception in terms relates only to pending proceedings. It contemplated future confirmation exclusively. The first exception, standing alone, literally could be applied in the case of a closed proceeding. But reaching such cases was not a necessary reason for including it. Such a reason existed, however, in the necessity for covering plans already confirmed in pending proceedings, unless parties then reorganizing under Section 77B were to be treated differently from others reorganizing at the same time under Chapter X. The two exceptions thus dovetailed to provide complete coverage for disallowing the exemption given by Section 268 in pending proceedings. They comprehended distinct situations and provided different sanctions, all however consistent with application only in pending proceedings. Thus the entire language of Section 276, sub. c(3) was capable of full and complete application, although confined to pending proceedings. To give it greater scope, retroactively, is required neither by the terms nor by the purposes of the specific provision or others related to it in context or by reference.

That the narrower application was the intended one seems most apparent when the nature of the problem with which Section 276, sub. c(3), sought to deal is considered. There was no problem, arising from enactment of the Chandler Act, with reference to closed 77B proceedings. And there was no reason originally, when Section 268 stood alone, for giving the relief it afforded to taxpayers involved in such proceedings. Nothing in the legislative history of Section 268, or of Section 270, shows any concern, intent or occasion for dealing with such taxpayers. The whole desire related rather, as has been shown, to taxpayers who might be adversely affected by the general revenue provisions in taking advantage of the Chandler Act.

However, that Act itself created another problem, namely, how far its terms should apply in pending 77B proceedings. Congress decided that the Chandler procedure should be followed as far as possible, though not to the extent of displacing the 77B procedure in reorganizations far advanced. The same policy was framed for other chapters. Consequently Sections 276, sub. c(1) and (2), were included, as were also comparable provisions in other chapters. With them in, the problem was presented whether the Chandler Act's tax relief provisions, including Sections 268 and 270, should apply also in the pending 77B proceedings and, if so, to what extent-only to those converted into Chandler Act proceedings by Section 276, sub. c(1), or also to those partially converted under Section 276, sub. c(2) by an exercise of judicial discretion and those falling within 276, sub. c(2) but so nearly completed or otherwise situated that application of the Chandler Act in any respect would be impracticable and therefore 77B would continue exclusively effective.

Although these pending 77B proceedings, and particularly those nearing completion, having been already begun, were generally without the scope of the encouragement Sections 268 and 270 were intended to give to persons contemplating reorganization, Congress undoubtedly felt it would be unfair to give the relief to taxpayers following the Chandler Act procedure, but deny it to persons following that of 77B at the same time. To make this discrimination might force conversion of pending 77B proceedings into Chapter X proceedings, solely on account of tax consequences, where but for them such conversion would not be proper or desirable. Accordingly, by Section 276, sub. c(3) Congress extended the tax relief provided by Sections 268 and 270 also to pending 77B proceedings in order to put persons continuing 77B reorganization on the same basis with others proceeding under Chapter X. There was no other occasion or object for the extension.

In view of these considerations both of context and of consequence, we do not think Section 276, sub. c(3) can be regarded as applicable to closed proceedings. The purpose rather, as in the other provisions of Section 276, was to look to the future and in doing so to make the necessary adjustment, so far as was possible, between the provisions of the Chandler Act and preexisting laws as to proceedings pending when the former took effect. Thus construed, Section 276, sub. c(3) becomes consistent, both in form and in the purpose and effects of applying the new tax provisions, with the other provisions of Section 276 and with the general policy of the Chandler Act as to applicability of its terms. Any other view would make Section 276, sub. c(3) a unique provision in the statute's setting and one inconsistent with, if not also contradictory to, the Act's general purposes and the limited objects of the particular provisions immediately in issue.

Further support for this view would seem to be afforded, when the consequences of applying it or the contrary one to similar provisions appearing in other chapters of the Chandler Act are taken into account. If those provisions are to be given retroactive application comparable to what the Government says should be given to Sections 268, 270 and 276, sub. c(3), the disruption of settled tax situations, by virtue of the Chandler Act's adoption, may be multiplied many times over what would follow from giving such an effect only to Sections 268, 270 and 276, sub. c(3). Although the immediate consequences of decision in this case are limited to the specific effects of these sections, it is at least doubtful that they could be given a different construction, as to retroactive application, from what might be given to the comparable sections of other chapters. The possibility that uniform interpretation may be required gives pause, at least, before adopting a view in this case which, if extended to the other provisions, would open so wide a door for retroactive taxation.

As against this interpretation, the Government's argument rests primarily on two bases: (1) that the words of Section 276, sub. c(3) require its construction; and (2) that unless this is given, discriminations as to tax consequences will be created between taxpayers involved in closed proceedings and those in pending and future ones, with the result that mere speed in getting the proceedings pending prior to September 22, 1938, to a final decree would determine whether taxpayers equally deserving would be afforded the relief provided by Sections 268 and 270.

The answers are obvious. In the first place, the wording of Section 276, sub. c(3) does not require the Government's construction. That view can be taken only if subdivision (3) is torn, formally and substantively, from its context in the statute and the problems with which these surrounding provisions, including Sections 268 and 270, undertook to deal. Thus to treat the provision not only would disregard the purposes of all these related provisions. It would convert subdivision (3), in its practical application, into an entirely independent tax measure, solely in the nature of an amendment to the general revenue legislation, and with the harshest retroactive tax consequences. This in fact seems to be the Government's view of the character of the legislation. But that view wholly disregards the fact that neither Sections 268 and 270 nor Section 276, sub. c(3) had any purpose originally or later merely to produce larger revenues or to operate exclusively as revenue measures. It is true they modified the preexisting revenue provisions, so far as they were applicable by their terms to do so. But this was a function of their primary object, which was to give relief to parties undertaking reorganization, not simply to impose new and different taxes upon them, much less to do so with respect to transactions long since settled both as to taxes and as to reorganization. The objects of Section 276, sub. c(3) cannot be ignored or distorted by thus stripping the provision, formally and substantively, from its statutory setting and the limitations this clearly imposes.

So far as respects the Government's concern over the possible discriminations which will be created between taxpayers by acceptance of petitioner's view, it is perhaps enough to say that some such discrimination is inevitable with whatever solution may be accepted; and we think what follows from applying Sections 268 and 270 only to 'pending proceedings' not only is preferable to any other but is most consistent with the normal course of legislation. Retroactivity, even where permissible, is not favored, except upon the clearest mandate. It is the normal and usual function of legislation to discriminate between closed transactions and future ones or others pending but not completed. The discrimination which the Government fears will follow from acceptance of the taxpayer's view admittedly will result. But it is one consistent with the normal consequences of legislation in the drawing of a line between the past or the present and the future. It also was one necessary for Congress to make if it were not to make another or others equally bad or worse. The Government's concern in this case is not that the taxpayer will suffer harsher discrimination under petitioner's construction than under its own. It is rather that he will not suffer it. For, as interpreted by the Government, Sections 268, 270 and 276, sub. c(3) applied in conjunction would be much more likely to produce new, and retroactive, tax burdens than tax benefits. The present case in an illustration. To this the Government might be entitled if the statutory mandate were clear. It cannot have that advantage by dubious construction which ignores so much of the statute's setting, purpose and history. The letter does not require this. The consequences forbid it.

There remains for consideration the refusal of the Court of Appeals to reverse the findings of the Tax Court as to the original cost of the apartment building and the propriety of deductions claimed in 1937 for decorating expenses. The Tax Court, in arriving at the cost of the building, refused to allow an alleged ten per cent contractor's commission paid to the debtor company's principal promoter and original sole shareholder because it was not convinced by petitioner's witness 'that any amount was actually paid by the old company for contractor's services. * *  * ' 1 T.C. 163, 175. The Tax Court also concluded, after hearing vague testimony on two small deductions in 1937 for decorating and repairs, that these were not properly taken, because the same deductions for the same purposes had been claimed and allowed in 1936. These issues were well within the principle of the Dobson case. The Tax Court was upheld in these respects by the Court of Appeals and we accept these findings.

Accordingly, the judgments are reversed and the causes are remanded to the Circuit Court of Appeals for further proceedings in conformity with this opinion.

Reversed and remanded.