UNITED STATES OF AMERICA, PETITIONER V. CENTENNIAL SAVINGS BANK FSB (RESOLUTION TRUST CORPORATION, RECEIVER) No. 89-1926 In The Supreme Court Of The United States October Term, 1989 The Acting Solicitor General, on behalf of the United States of America, petitions for a writ of certiorari to review the judgment of the United States Court of Appeals for the Fifth Circuit in this case. Petition For A Writ Of Certiorari To The United States Court Of Appeals For The Fifth Circuit TABLE OF CONTENTS Questions Presented Opinions below Jurisdiction Statutory provisions and regulation involved Statement Reasons for granting the petition Conclusion OPINIONS BELOW The opinion of the court of appeals (App., infra, 1a-29a) is reported at 887 F.2d 595. The opinion of the district court (App., infra, 30a-60a) is reported at 682 F. Supp. 1389. JURISDICTION The judgment of the court of appeals was entered on November 2, 1989. A petition for rehearing was denied on January 19, 1990 (App., infra, 61a-62a). On April 10, 1990, Justice White extended the time within which to file a petition for a writ of certiorari to and including May 18, 1990. On May 4, 1990, Justice White further extended that time to and including June 8, 1990. The jurisdiction of this Court is invoked under 28 U.S.C. 1254(1). STATUTORY PROVISIONS AND REGULATION INVOLVED The relevant portions of Sections 108, 165, and 1001 of the Internal Revenue Code of 1954 (26 U.S.C. (1982)) and Section 1.1001-1(a) of the Treasury Regulations on Income Tax (26 C.F.R.) are set out in a statutory appendix (App., infra, 63a-66a). QUESTIONS PRESENTED 1. Whether a financial institution realizes a deductible loss for income tax purposes when it exchanges a group of mortgage loans for a substantially identical group of mortgage loans held by another financial institution. 2. Whether income received by a financial institution from its depositors as penalties for early withdrawal of their funds is excludable from gross income as income from "the discharge * * * of indebtedness," within the meaning of Section 108 of the Internal Revenue Code. STATEMENT 1. a. Respondent is a mutual savings and loan association formerly regulated by the Federal Home Loan Bank Board. In 1981, respondent's mortgage loan portfolio was comprised primarily of fixed-rate, long-term home mortgage loans that had been issued in the late 1960s at interest rates significantly lower than those charged on more recent loans. As a result of the high interest rates of the early 1980s, the fair market value of these older, low-interest loans fell far below their face amount. App., infra, 31a. For respondent, like other savings institutions holding older, low-interest loans, this situation created a tax incentive for disposing of its depreciated mortgage loans. A disposition of the loans would enable respondent to realize for tax purposes the loss that resulted from these market changes; it could then utilize the resulting loss deductions to offset current taxable income and produce loss carrybacks that would generate tax refunds from prior years. There was, however, a catch. Many of these institutions were in such precarious financial condition that a sale of the loans and consequent recognition of the losses -- however beneficial for tax purposes -- would for regulatory accounting purposes have caused them to fail to meet the Bank Board's minimum reserve and liquidity requirements, raising the prospect of closure by the Bank Board. See App., infra, 31a-32a; San Antonio Savings Ass'n v. Commissioner, 887 F.2d 577, 579 (5th Cir. 1989). On June 27, 1980, the Bank Board's Office of Examination and Supervision (OES) issued Memorandum R-49, a regulatory accounting principle that adopted the rule that savings institutions could make "reciprocal sales" of depreciated "substantially identical mortgage loans" without having to record a loss for regulatory accounting purposes. Memorandum R-49 established a list of criteria that would render loans "substantially identical," including that the mortgages be of similar type with the same terms and interest rates. /1/ The admitted objective of Memorandum R-49 was to allow savings institutions to engage in transactions that would generate deductible losses for federal income tax purposes, but that would not be treated as giving rise to losses for financial reporting and regulatory purposes. See App., infra, 53a-54a; San Antonio Savings Ass'n v. Commissioner, 887 F.2d at 579-580. /2/ On April 13, 1981, respondent entered into a transaction in which it effectively exchanged a package of interests in a group of residential mortgage loans for a package of interests in a group of residential mortgage loans held by the Federal National Mortgage Association (FNMA), a congressionally chartered, but privately owned, corporation that is the principal buyer and seller of mortgages in the secondary mortgage market. The interests were exchanged through "reciprocal sales" of conventional and FHA/VA loan packages having almost identical face and market values. The parties planned the transaction so as to ensure that the exchanged loans met the requirements of Memorandum R-49. FNMA used a computer to match respondent's loans with its own loans, and it then sent to respondent a list of FNMA loans that it proposed to exchange for a group of respondent's loans. Respondent agreed to acquire all of the proposed loans, without conducting any new credit checks, appraisals, or underwriting of those loans and without reviewing any of the relevant mortgage file documents. The valuation of all of the loans was established by reference to FNMA's new money auction rate for April 1981. To arrive at a sale price, one discount factor was applied to each side of the transaction on all conventional loans and another discount factor was applied to all FHA/VA loans. App., infra, 35a-37a. The transaction was styled a "reciprocal sale" and was consummated by conveyance of 90% participation interests in each loan together with a simultaneous wire transfer of money by respondent and FNMA to each other's account. /3/ Respondent thus paid FNMA $5,662,045 for participation interests with a face amount of $8,481,264, while at the same time FNMA paid respondent $5,662,043 for participation interests with a face amount of $8,481,261. In effect, respondent exchanged participation interests with a face amount (and cost basis) of $8,481,261, but a much lower value, for participation interests of almost equal value. On its 1981 federal income tax return, respondent claimed a deduction for a loss on the transaction of $2,819,218, the difference between the face amount and value of the participation interests that it transferred. Pursuant to Memorandum R-49, however, respondent did not report any loss for financial and regulatory accounting purposes. App., infra, 2a-3a, 34a-35a. b. During 1981, respondent had many certificates of deposit outstanding. Each certificate of deposit agreement established the interest rate to be paid on the deposit and a fixed term for which the depositor was to keep the funds on deposit with respondent. If a depositor chose to withdraw the principal from one of these accounts prior to maturity, federal regulations required the depositor to pay an "early withdrawal penalty" to respondent. See 12 C.F.R. 526.7 (1979); 12 C.F.R. 526.7 (1980); 12 C.F.R. 1204.103 (1981). Under the terms of the certificates, when a depositor incurred a penalty for withdrawing his deposit before expiration of the fixed term he would receive a single net payment from respondent -- consisting of the principal on deposit plus interest payable to the date of withdrawal, less the penalty. The penalty thus was "paid" not by a direct transfer of funds from the depositor to respondent, but rather by subtracting the amount of the penalty from the amount paid to the depositor on the certificate. App., infra, 11a & n.4, 54a-55a. During 1981, respondent received $258,019 in early withdrawal penalties. On its 1981 return, respondent treated the penalties as income from the discharge of indebtedness (see 26 U.S.C. 61(a)(12)), and it excluded that amount from its gross income under Section 108 of the Code. /4/ App., infra, 4a, 55a. In 1981, that statute effectively allowed a taxpayer to defer the recognition of amounts included in gross income by reason of the discharge of indebtedness by generally providing that such income could be excluded from gross income if the taxpayer made an election under Section 1017 of the Code to reduce the basis of its depreciable property by the amount excluded. /5/ 2. On audit, the IRS determined that respondent was not entitled to its claimed deduction for a loss on the mortgage exchange transaction. The IRS further determined that respondent was required to include the early withdrawal penalties in gross income. Respondent paid the resulting income tax deficiencies and filed this refund action in the United States District Court for the Northern District of Texas. App., infra, 3a-4a. /6/ After a bench trial, the district court ruled for the government on the mortgage swap issue and for respondent on the early withdrawal penalty issue (id. at 30a-60a). a. The court first concluded that, even though the mortgage transaction had been structured as two simultaneous reciprocal sales, it was essentially an exchange of mortgage loans (App., infra, 44a-47a). It then concluded that this exchange was not an event that gives rise to realization of gain or loss under Section 1001 of the Code (id. at 47a-54a). Relying on Treas. Reg. Section 1.1001-1(a) and addressing the relevant case law, the court explained that a loss is realized on an exchange of properties only if the properties are "materially different" (id. at 47a-50a). The court then held that, considering the "economic realities in existence at the time of the transaction" (id. at 51a), the mortgages exchanged here were not materially different, and hence the exchange could not give rise to a deductible loss (id. at 50a-54a). The court explained that the exchanged loans had been carefully selected so that they would be viewed as "substantially identical" under Memorandum R-49, and it concluded that "(t)he R-49 criteria assured that the mortgages after the matching process would not be materially different" (id. at 51a). The court recognized that each individual loan was different from the others, but it found that the "'pools' of mortgage * * * were swapped with little if any reference to possible differences in the individual characteristics of the loans involved"; it then concluded that it is "difficult to attach significance to loan characteristics of which (respondent) itself had no knowledge at the time of the transaction." Id. at 52a. b. The court agreed with respondent that the early withdrawal penalties were income by reason of the discharge of indebtedness that could be excluded from gross income under Section 108 of the Code (App., infra, 54a-60a). The court stated that "the penalty provision is an integral part of the contract, not merely an ancillary 'method' or 'medium' by which the debt was reduced" and therefore "the penalty income was liquidated debt, not liquidated damages" (id. at 59a). The court concluded that "income received by (respondent) from premature withdrawals was a direct result of depositors discharging (respondent) from its indebtedness to them" (ibid.). 3. Both parties appealed, and the court of appeals reversed the district court's decision with respect to the mortgage exchange issue and affirmed with respect to the early withdrawal penalty issue (App., infra, 1a-29a). This case was heard together with two other cases involving mortgage exchanges that satisfied the criteria of Memorandum R-49, and all three cases were decided by the same panel on the same day. See San Antonio Savings Ass'n v. Commissioner, supra; First Federal Savings & Loan Ass'n v. United States, 887 F.2d 593 (5th Cir. 1989). a. The court of appeals treated San Antonio as the lead case, and it held there that an exchange of mortgages that satisfied the criteria of Memorandum R-49 could still give rise to a deductible loss for tax purposes. The court of appeals agreed with the district court and the government that a loss is realized on an exchange only if the properties exchanged are materially different (887 F.2d at 581-587). The court observed that, if the rule were otherwise, there would be "no limits on realization through meaningless exchanges," such as an exchange of different bushels of indistinguishable wheat (id. at 583). After an extensive review of the case law, the court concluded that "there is a material difference requirement which has been developed by the cases and confirmed by the Treasury Regulations" (id. at 587). The court then held, however, that the mortgages exchanged in an R-49 transaction are "materially different" because the mortgages have different borrowers and different collateral, even though the Bank Board had identified the mortgages as "substantially identical" (id. at 587-592). The court acknowledged that these variations made no difference to the parties to the exchange, but it stated that "(i)t must be the objective and not subjective factors, * * * which determine whether a realization event occurred" (id. at 590). The court also rejected the government's additional argument that the exchange lacked economic substance and therefore that no loss could be deducted under Section 165 of the Code (id. at 592-593). In this case, the court observed that the facts relevant to the mortgage exchange issue were essentially the same as the facts in San Antonio (App., infra, 3a). Accordingly, it held that respondent's "R-49 transaction resulted in a realized and recognizable loss for tax purposes because the participation interests exchanged were in mortgages which under the Internal Revenue Code differed materially from each other" (id. at 9a). b. The court of appeals agreed with the district court that the early withdrawal penalties received by respondent constituted income from the discharge of indebtedness and therefore that respondent was entitled to defer reporting that income pursuant to Section 108 of the Code (App., infra, 9a-28a). The court stated that the determination whether income should be regarded as "from the discharge of indebtedness" "focus(es) on the final result" -- specifically, "on the spread between the amount received by the debtor and the amount paid by him to satisfy his obligation" (id. at 12a). The court reasoned that this approach supported respondent's position here since the effect of the penalty was to reduce respondent's net obligation to its depositor (ibid.), and it found no reason to reach a different result. In so holding, the court expressly disagreed (id. at 28a) with the decisions of the Tax Court and the Seventh Circuit in Colonial Savings Ass'n v. Commissioner, 85 T.C. 855 (1985), aff'd, 854 F.2d 1001 (7th Cir. 1988), cert. denied, 109 S. Ct. 1556 (1989), which had both concluded that early withdrawal penalties do not constitute income from the discharge of indebtedness that may be excluded under Section 108. /7/ REASONS FOR GRANTING THE PETITION This case presents two unrelated questions concerning the federal income tax treatment of two kinds of transactions engaged in by savings and loan associations and other financial institutions. Because these kinds of transactions were and are common to the operations of many such institutions, the resolution of each question affects numerous financial institutions around the country and involves many millions of dollars. Moreover, there is a direct conflict in the circuits with respect to each of these questions of industry-wide significance. Unless these conflicts are resolved by this Court, taxpayers will receive disparate treatment, based entirely upon the happenstance of their geographical location, in numerous cases involving substantial sums of money. 1. The decision of the court below with respect to the tax treatment of the mortgage exchange transactions directly conflicts with the Sixth Circuit's decision in Cottage Savings Ass'n v. Commissioner, 890 F.2d 848 (1989). In this case (and in its decision in the lead case of San Antonio Savings Ass'n v. Commissioner, 887 F.2d 577 (1989)), the Fifth Circuit has held that pools of mortgages regarded as "substantially identical" by the parties and by the Federal Home Loan Bank Board under Memorandum R-49 are nonetheless "materially different" for tax purposes. Therefore, under the Fifth Circuit's holdings, exchanges of "substantially identical" mortgage interests that have depreciated in value are events that allow taxpayers to realize their losses and to use those losses to offset their taxable income. The Sixth Circuit took a different approach and reached the contrary conclusion in Cottage Savings. The court there held that because the exchange of mortgages pursuant to Memorandum R-49 did not result in any real change in the taxpayer's economic position, the taxpayer had not "sustained" a loss on that transaction that would permit it to take a loss deduction under Section 165 of the Code. In particular, the court stated that loss deductions are not allowed on "transactions in which the taxpayer's economic position was not changed for the worse" (890 F.2d at 854), and it concluded that a savings institution's "economic position was not changed" by an exchange of a pool of mortgages for "a substantially identical pool of mortgages" (id. at 855). The decisions of these two circuits are irreconcilable. The Sixth Circuit in Cottage Savings held that no loss is "sustained" within the meaning of Section 165 upon a Memorandum R-49 mortgage exchange and therefore that such an exchange does not permit the taxpayer to take a loss deduction. The Fifth Circuit, by contrast, explicitly held that the Memorandum R-49 exchanges of substantially identical mortgages solely to achieve a tax benefit did result in a loss deductible under Section 165. See San Antonio, 887 F.2d at 592-593. /8/ This disagreement between the circuits will lead to different results in every case involving an exchange of depreciated mortgages that meet the criteria of Memorandum R-49. Under the Fifth Circuit's rule, a loss is realized upon such an exchange, and that loss may be deducted. Under the Sixth Circuit's rule, such an exchange lacks sufficient economic substance to permit the deduction of any loss. There is no prospect that this conflict among the circuits will be resolved without the intervention of this Court. The government sought rehearing en banc of the Fifth Circuit cases, calling to the court's attention the contrary decision in Cottage Savings, but the court of appeals denied the petition. /9/ By the same token, the taxpayer in Cottage Savings sought rehearing en banc in the Sixth Circuit, calling to the court's attention the conflict with the Fifth Circuit. The Sixth Circuit denied rehearing on March 14, 1990. The continuation of this conflict will lead to disparate results among taxpayers in numerous cases involving enormous sums. The IRS has advised that there are currently pending administratively and in the courts 96 cases involving approximately $419 million in taxes (excluding interest) that turn on the resolution of the mortgage exchange issue. Accordingly, it is appropriate for this Court to grant certiorari here in order to resolve the conflict in the circuits on this issue of industry-wide significance. /10/ 2. The court below erred in holding that mortgage exchanges designed to meet the Memorandum R-49 criteria for "substantially identical" mortgage pools give rise to a deductible loss. It is black letter law that the Internal Revenue Code generally takes into account increases and decreases in the value of property, other than inventory, only when gains or losses are "realized" in a taxable event that disposes of the property. See I.R.C. Section 1001; see also I.R.C. Section 165(a) (deduction allowed for "any loss sustained during the taxable year * * *"). And the Treasury Regulations have long defined a realization event in terms of the conversion of property into cash or an "exchange of property for other property differing materially either in kind or in extent." Treas. Reg. Section 1.1001-1(a). /11/ This requirement that exchanged property be materially different if an exchange is to constitute a realization event reflects one of the fundamental principles of taxation -- that the substance rather than the form of a transaction determines its tax consequences. See, e.g., Commissioner v. Court Holding Co., 324 U.S. 331, 334 (1945); Gregory v. Helvering, 293 U.S. 465, 469-470 (1935). In particular, this Court has recognized that a taxpayer cannot deduct a loss generated by a transaction that lacks economic substance. See Higgins v. Smith, 308 U.S. 473 (1940) (sale of devalued stock to taxpayer's wholly-owned corporation). A taxpayer who exchanges property for other property that is not materially different has disposed of his property only as a matter of form, but there is no change in substance because the taxpayer is in essentially the same position as before the transaction. Accordingly, as the court of appeals below correctly held here and in its decision in San Antonio, 887 F.2d at 581-587, "a 'material difference' is required between exchanged items before a realization event can be held to occur" (App., infra, 8a). Accord Federal Nat'l Mortgage Ass'n v. Commissioner, 896 F.2d 580, 583 (D.C. Cir. 1990). /12/ Although the court below upheld the longstanding position reflected in Treas. Reg. Section 1.1001-1(a) that a loss can be realized on an exchange only if the properties are "materially different," the court proceeded to eviscerate that requirement by construing the phrase "materially different" so narrowly as to render the term "materially" essentially meaningless. The court held (see San Antonio, 887 F.2d at 587-592) that loans that satisfy the Memorandum R-49 criteria are "materially different" merely because the loans have different borrowers and are secured by different collateral. The court gave no satisfactory explanation, however, for why these differences should be regarded as "material." It seems clear that a materiality requirement, at a minimum, means that the difference must actually matter to somebody. Compare Kungys v. United States, 485 U.S. 759, 770-771 (1988) (the term "material" in the criminal and naturalization context means having "a natural tendency to influence (a) decision"). But it is undisputed here that the differences (in individual borrowers and property secured by the mortgages) on which the court below relied did not matter to any of the interested parties -- respondent, its trading partner, the secondary mortgage market, or the Bank Board, which was the agency charged by Congress with regulating federal savings and loan associations. See App., infra, 51a-52a. Thus, the court below effectively held that respondent was entitled to its claimed loss deduction merely because the loans it transferred were not the same in every respect as the loans it received in exchange -- without regard to whether those differences were significant. This holding exalts form over substance and severely undermines the efficacy of the realization requirement by allowing differences of no consequence to anyone to be deemed "material," thereby permitting a deductible loss for federal tax purposes to be generated by a transaction that no one regarded as changing the participants' economic position. The Fifth Circuit suggested in San Antonio, 887 F.2d at 589-591, that the differences in individual borrowers and collateral were material because they would tend to make the mortgage loans perform differently over time -- i.e., one mortgage loan would turn out to be a worse investment than the other. While it is true that these individual differences could have been expected to yield some disparities in future performance -- one borrower might default or one home might decrease in value more than another -- it is equally true that the interested parties nonetheless regarded these differences as immaterial. There is no evidence that it would be practical for an exchange participant to attempt to predict future performance based on these differences, and respondent plainly made no effort to assess their significance; it conducted no credit checks on the borrowers or appraisals of the collateral. App., infra, 52a. At most, respondent knew that theoretically any one loan might be riskier than another, but neither respondent nor its trading partner attempted to evaluate the comparative risks or to take any account whatsoever of a possible variance in risk between the loans it was transferring and the loans it was receiving in return. /13/ Moreover, the district court also found (id. at 52a-53a) that the entire secondary mortgage market, which routinely deals with packages of residential mortgages, similarly regarded as irrelevant differences among individual borrowers and collateral. See also First Federal Savings & Loan Ass'n v. United States, 694 F. Supp. 230, 245 (W.D. Tex. 1988) ("loans meeting the criteria of Memorandum R-49 are considered economically indistinguishable" by the secondary market), aff'd, 887 F.2d 593 (5th Cir. 1989). Thus, the differences in the exchanged mortgages relied upon by the Fifth Circuit did not affect in any way the nature of the transactions or the decisional process of the parties, and they cannot reasonably be characterized as "material" for realization purposes. /14/ The conclusion that the exchanged mortgages were not "materially different" is strongly buttressed by Memorandum R-49 itself. That document represents the considered opinion of the agency then charged by Congress with, inter alia, providing rules and regulations for the "examination, operation, and regulation" of federal savings and loan associations. 12 U.S.C. 1464(a). Accordingly, the Bank Board's determination that mortgages that meet the criteria of Memorandum R-49 are "substantially identical" is entitled to considerable respect. See Ford Motor Credit Co. v. Milhollin, 444 U.S. 555, 566 (1980). While acknowledging that its decision "seems illogical" (San Antonio, 887 F.2d at 591), the Fifth Circuit dismissed the Bank Board's opinion as having "no direct relevance" (ibid.), stating that "'substantial identity'" is "a different concept for a different administrative purpose from the IRS's concept of 'material difference' for tax purposes" (App., infra, 8a). This explanation is untenable because the administrative purposes served by the "substantially identical" standard and the "materially different" standard are in fact quite similar. The purpose of Memorandum R-49, as stated by the Bank Board unit responsible for its promulgation, was to provide a blueprint for a transaction that would not "change the economic position" of the parties to the transaction. See San Antonio, 887 F.2d at 580. This characterization was the cornerstone of the Memorandum because a change in economic position would have required the parties to disclose their losses for financial and regulatory purposes -- which the parties clearly wanted to avoid, because of the problem of satisfying the Bank Board's minimum net worth and liquidity standards. /15/ Similarly, the purpose of the "materially different" requirement for realization in Treas. Reg. Section 1.1001-1(a) is to provide that gain or loss is realized only if a taxpayer changes his economic position, i.e., realizes a loss in substance as well as in form. Thus, the two phrases in question are addressed not to "different administrative purpose(s)" (App., infra, 8a), but to essentially the same inquiry into economic substance, and the Bank Board's expert opinion that mortgages satisfying the Memorandum R-49 criteria are "substantially identical" is highly relevant to the tax question presented here. /16/ As the district court concluded in First Federal (694 F. Supp. at 245), "it becomes almost ludicrous to suggest that R-49 loans are at the same time 'substantially identical' for financial accounting purposes and 'materially different' for tax accounting purposes when the objective of both systems in this context is to accurately describe economic reality." It is appropriate for this Court to grant certiorari to correct this error by the court of appeals, which has major industry-wide significance and, if allowed to persist, will result in millions of dollars of uncollected taxes. 3. a. The decision below also creates a direct conflict in the circuits on the second question presented -- the income tax treatment of early withdrawal penalties received by respondent from its depositors. The court of appeals explicitly acknowledged (App., infra, 28a) that its holding that early withdrawal penalties received by a savings institution are excludable from gross income under Section 108 of the Coe is irreconcilable with the Seventh Circuit's decision in Colonial Savings Ass'n v. Commissioner, 854 F.2d 1001 (1988), cert. denied, 109 S. Ct. 1556 (1989). /17/ Both cases involved the tax treatment of a savings institution's receipt of early withdrawal penalties from its customers when they withdrew the principal from fixed-term savings certificates prior to maturity, with the penalties paid by means of an offset against the amounts owed to the customers on the savings certificates. The Seventh Circuit held that early withdrawal penalties are not income from discharge of indebtedness within the meaning of Section 108 and, accordingly, held that the penalties were not excludable from gross income. 854 F.2d at 1004-1007. The court explained that the income "did not arise 'by reason of the discharge of indebtedness.' Rather it arose by reason of the creditor's alteration of the parties' contract and the consequential expenses of the bank/debtor." Id. at 1007. The court below, however, "respectfully disagree(d)" (App., infra, 9a) with the Seventh Circuit and held that such income does arise by reason of the discharge of indebtedness, and therefore that the income may be excluded from gross income under Section 108. Accordingly, there is a square conflict in the circuits on this issue. Resolution of this conflict is of considerable administrative importance. Fixed-term savings certificates with early withdrawal penalties are a common method of saving, and therefore the tax treatment of amounts received as penalties is of industry-wide significance. The IRS has advised us that there are pending administratively and in the courts 108 cases involving approximately $128 million in income tax liabilities (excluding interest) that turn on this question. We note, however, that the importance of this issue for future years has been diminished by the 1986 amendment of Section 108 limiting its application to situations in which the taxpayer is insolvent or the discharge of indebtedness occurs in a bankruptcy case. See note 5, supra. Thus, for years after 1986, a solvent savings institution can no longer elect under Section 108 to exclude early withdrawal penalties from its gross income. Because of the volume of litigation and large amount of tax revenue at stake in cases arising in pre-1986 tax years, we nonetheless believe that it is appropriate for this Court also to resolve the circuit conflict on the early withdrawal penalty issue, thereby preventing disparate results in many cases based solely on the geographical location of the taxpayer. b. The court below erred in permitting respondent to exclude from gross income the amount it received as early withdrawal penalties. It is not disputed that these early withdrawal penalties constitute income to respondent. The question rather is whether they qualify as a particular type of income -- realized "by reason of the discharge (in whole or in part) of indebtedness of the taxpayer" -- that qualifies for special treatment under Section 108 of the Code. That Section provides generally that such income may be excluded from gross income if the taxpayer elects under Section 1017 to reduce its basis in depreciable property it owns by an amount equal to the amount excluded. The effect of that election is to defer the tax on the debt discharge income; the tax is ultimately collected indirectly because the taxpayer must take lower depreciation deductions for the reduced-basis assets or recognize greater gains on their sale. It is well established as a general rule that a taxpayer realizes income from the discharge of a debt when the debt is forgiven, cancelled, or otherwise discharged for less than its face amount. See Commissioner v. Jacobson, 336 U.S. 28, 38-40 (1949); United States v. Kirby Lumber Co., 284 U.S. 1 (1931). The predecessor of Section 108 was enacted to provide relief from the Kirby Lumber principle for certain debtors. Section 22(b)(9) of the Internal Revenue Code of 1939 (26 U.S.C. (1952)), as enacted by Section 215(a), Revenue Act of 1939, ch. 247, 53 Stat. 875, provided that a corporation "in an unsound financial condition" could exclude the amount of any income "attributable to the discharge * * * of any indebtedness * * * evidenced by a security," if the corporation elected to reduce its basis in property under Section 113(b)(3) of the 1939 Code (the predecessor of Section 1017). In 1942, Congress broadened the reach of this section by removing the requirement that the corporation be in an "unsound financial condition." See Section 114(a) of the Revenue Act of 1942, ch. 619, 56 Stat. 811. The general purpose of the provision was to facilitate a corporation's ability to strengthen its financial position through retirement of outstanding debt -- by allowing deferral of the tax on the resulting debt discharge income (which ordinarily would not produce cash or other assets that could be used to pay the tax). See generally Wright, Realization of Income Through Cancellations, Modifications, and Bargain Purchases of Indebtedness, 49 Mich L. Rev. 459 (1951). /18/ It is well settled that income "by reason of the discharge * * * of indebtedness within the meaning of Section 108 is not produced every time a debt is cancelled or discharged. If the cancellation of a debt is not, in and of itself, the source of the income, but simply the method by which a creditor makes a payment to a debtor, then the debtor does not have income "by reason of" a debt discharge; he has income "by reason of" receiving a payment. Such income does not qualify for the Section 108 exclusion. See OKC Corp. v. Commissioner, 82 T.C. 638, 647-649 (1984); S. Rep. No. 1035, 96th Cong., 2d Sess. 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."). The court of appeals in this case agreed with this proposition (see App., infra, 15a-18a), and it did not take issue with the Seventh Circuit's statement in Colonial that "when the discharge of indebtedness is a mere medium for the payment of a separate obligation between two parties, section 108 does not apply" (854 F.2d at 1005). The court below held, however, that this "method of payment" principle is not applicable here because the court did not view the early withdrawal penalty as a "separate obligation." See App., infra, 18a-21a. That ruling is erroneous. Respondent's depositors were bound by federal regulations to pay a penalty to respondent in order to withdraw the principal from one of respondent's fixed-term accounts prior to maturity. See 12 C.F.R. 526.7 (1979); 12 C.F.R. 526.7 (1980); 12 C.F.R. 1204.103 (1981). Respondent collected these penalties by reducing the amount otherwise payable to the depositors. If, instead, the depositors had paid the penalties to respondent in cash and in turn received the entire amount due on the certificates, respondent would have had income in the amount of the penalty and that income clearly would not have been income from the discharge of indebtedness. The result should be no different where, as here, the method of paying the penalty was by reducing the amount turned over to the depositor. /19/ In short, respondent did not have income "by reason of" the discharge of indebtedness; it had income "by reason of" receiving a penalty. Income from the discharge of indebtedness is realized where a debt is discharged for less than its face amount, i.e., where all or a portion of the debt is forgiven. Here, although the debt owed to a depositor was "discharged" in the sense that it was extinguished, it was not discharged for less than face value. The portion of the debt that respondent did not pay to the depositor was not forgiven by the depositor, but rather was used to satisfy -- i.e., to pay -- the penalty obligation owed by the depositor. Thus, the Seventh Circuit correctly concluded in Colonial (854 F.2d at 1007) that "early withdrawal penalties represent separate obligations from depositors to (savings institutions)," and therefore they are not encompassed within Section 108 of the Code. The Fifth Circuit's contrary conclusion that the penalty did not represent a separate obligation of the depositor rests primarily upon its observation that the penalty was "an integral part of the CD arrangement" and that "(n)o separate contract created the CD penalty" (App., infra, 20a). But the fact that there was but one contract between respondent and a depositor does not mean that there was only one obligation involving respondent and that depositor. Respondent's obligation to its depositor when he cashed in a savings certificate was typical of the traditional relationship between a debtor-bank and a creditor-customer. The penalty was a distinct obligation owed to respondent by the depositor once he elected to make an early withdrawal. Contrary to the Fifth Circuit's statement (id. at 23a), the penalty was not "bargained for as an integral part of the single transaction"; rather, the penalty was imposed from outside the parties' debtor-creditor relationship by federal regulations. Respondent's decision to have that distinct obligation satisfied by reducing its payment on the certificate -- a mere matter of form -- should not permit it to achieve a substantial tax benefit under Section 108 by excluding from gross income the amounts it received as early withdrawal penalties. CONCLUSION The petition for a writ of certiorari should be granted. Respectfully submitted. JOHN G. ROBERTS, JR. Acting Solicitor General /20/ SHIRLEY D. PETERSON Assistant Attorney General LAWRENCE G. WALLACE Deputy Solicitor General ALAN I. HOROWITZ Assistant to the Solicitor General RICHARD FARBER BRUCE R. ELLISEN Attorneys JUNE 1990 /1/ Memorandum R-49 specifically provided in part (App., infra, 32a-33a): A loss resulting from a difference between market value and book value in connection with reciprocal sales of substantially identical mortgage loans need not be recorded. Mortgage loans are considered substantially identical only when each of the following criteria is met. 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 2 1/2% 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. /2/ A memorandum from the Director of OES to an officer of the Bank Board described the "objective" of Memorandum R-49 as "to structure a transaction which was as close as possible to the IRS 'materially different' definition which would still not change the economic position of the association after it engaged in the swap." See San Antonio Savings Ass'n v. Commissioner, 887 F.2d at 580. /3/ Transactions designed to take advantage of Memorandum R-49 often involved exchanges of 90% participation interests, rather than the entire loan, so that the original mortgagee could maintain its relationship with the obligor on the loans. See Cottage Savings Ass'n v. Commissioner, 90 T.C. 372, 381 (1988), rev'd, 890 F.2d 848 (6th Cir. 1989). /4/ Unless otherwise indicated, statutory references are to the Internal Revenue Code of 1954 (26 U.S.C. (1982)), as in effect for the years at issue (the Code or I.R.C.). /5/ Section 108 was amended by the Tax Reform Act of 1986 to limit its application, for future years, to situations in which the taxpayer is insolvent or the discharge of indebtedness occurs in a bankruptcy case. See Pub. L. No. 99-514, Section 822(a), 100 Stat. 2373. /6/ Respondent reported a net operating loss on its 1981 return. It carried back this loss to the years 1969, 1970, and 1972-1980, resulting in overpayments of taxes for those years. Respondent filed claims for tentative refunds of those overpayments, and the IRS disbursed the claimed refunds. The IRS disallowed the net operating loss claimed for 1981 and made an assessment against respondent in the amount of $788,634 plus interest. App., infra, 3a-4a. Thus, although the two issues presented here relate to respondent's income tax liability for 1981, the amounts at issue involve the refunds claimed by respondent for earlier tax years, based on net operating loss carrybacks from 1981. /7/ While the case was pending on appeal, respondent was found insolvent by the Bank Board, and the Federal Savings and Loan Insurance Corporation was appointed as receiver. Subsequently, the Resolution Trust Corporation (RTC) took over as receiver. By statute, the Federal Deposit Insurance Corporation "perform(s) all responsibilities" of the RTC. See Section 501 of the Financial Institutions Reform, Recovery, and Enforcement Act of 1989, Pub. L. No. 101-73, 103 Stat. 369 (to be codified at 12 U.S.C. 1441a(b)(1)(C)). /8/ The Fifth Circuit accepted the government's submission that no loss may be "realized" under Section 1001 upon an exchange of properties that are not "materially different." The court then proceeded to hold that the exchanged mortgages satisfied that standard. The Sixth Circuit, by contrast, held that there is no "materially different" requirement for realization of gain or loss on an exchange. Accordingly, it did not explicitly address the question whether these mortgages were "materially different," but instead proceeded directly to the question whether there was a loss that could be deducted under Section 165 and concluded that no deductible loss had been sustained because there was no real change in the taxpayer's economic position. /9/ In addition, the D.C. Circuit has recently decided the same issue in agreement with the position of the Fifth Circuit below. See Federal Nat'l Mortgage Ass'n v. Commissioner, 896 F.2d 580, 583-585 (1990). /10/ As we have noted, three cases decided by the Fifth Circuit on the same day present the mortgage exchange issue. We urge the Court to grant certiorari in this one because it also presents a second issue of industry-wide significance and considerable administrative importance. See pages 20-26, infra. We have also filed today a petition for certiorari from the court's judgment in First Federal Savings & Loan Ass'n v. United States, 887 F.2d 593 (5th Cir. 1989). Because that case involves a solvent savings institution, and this case involves an institution in RTC receivership, we believe that it would be appropriate also to grant the petition in First Federal. The taxpayer in San Antonio Savings Ass'n v. Commissioner, supra, is also in RTC receivership, and there is a question whether the tax deficiency in that case, if sustained, can ever be collected. Because this doubt about the collectibility of the deficiency in turn raises a question of mootness (see Triland Holdings & Co. v. Sunbelt Service Corp., 884 F.2d 205, 208 (5th Cir. 1989)), we do not urge the Court to grant plenary review in San Antonio, but rather suggest that the petition in that case (filed today) be held pending the Court's resolution of the mortgage exchange issue in another case. In contrast to San Antonio, the insolvency of the taxpayer in this case presents no question of collectibility or mootness because this is a refund suit in which the United States has possession of the disputed taxes, and the question is whether those amounts must be refunded. /11/ This language dates back to the regulations under the Revenue Act of 1934. See Treas. Reg. 86, Art. 111-1. /12/ Similarly, a taxpayer cannot be said to have sustained a loss deductible under Section 165 by virtue of a transaction that lacks economic substance. Treas. Reg. Section 1.165-1(b) provides in part: "Only a bona fide loss is allowable. Substance and not mere form shall govern in determining a deductible loss." See generally Cottage Savings Ass'n v. Commissioner, 890 F.2d at 854-855; see also Horne v. Commissioner, 5 T.C. 250 (1945) (no deduction allowed where taxpayer sold his seat on commodity exchange at a loss within a month of purchasing another seat); Shoenberg v. Commissioner, 30 B.T.A. 659 (1934) (no loss allowed where taxpayer sold devalued stock and his wholly-owned corporation simultaneously purchased identical stock), aff'd, 77 F.2d 446 (8th Cir.), cert. denied, 296 U.S. 586 (1935). /13/ Obviously, to the extent an individual loan in the exchanged mortgage pools was riskier than the others, it was correspondingly less valuable (since the terms of the loans in the Memorandum R-49 transactions were identical). Yet respondent and its trading partner did not draw distinctions among individual loans in valuing them; the parties applied a common discount factor to value all of the loans exchanged. This equality of treatment could indicate one of several things: (1) the parties viewed each loan as being equally risky; (2) the parties recognized that there might be disparities in the relative riskiness of similar loans, but they could not tell which loans were riskier, and thus could not take the differences into account in the terms of the exchange; or (3) given the large number of mortgages contained in each pool, risk differences in individual loans were statistically insignificant and did not alter the fact that each pool of mortgages was an equally risky investment (see First Federal Savings & Loan Ass'n v. United States, 694 F. Supp. 230, 245 n.15 (W.D. Tex. 1988), aff'd, 887 F.2d 593 (5th Cir. 1989)). In any event, the differences in the identity of the borrower and the particular property securing the loan simply did not matter to the parties involved in the transactions, and those differences should not be viewed as "material." /14/ The Fifth Circuit stated that the marketplace's opinion that different mortgages were economically indistinguishable was not relevant to the "materially different" inquiry. See San Antonio, 887 F.2d at 589-590. This conclusion appears to reject what is generally the most obvious and reliable barometer for assessing whether particular attributes of property are "material" (compare Emery v. Commissioner, 166 F.2d 27, 29 (2d Cir. 1948) (referring to how the "investing public" viewed the differences between bonds as part of determination that those differences were material); Hanlin v. Commissioner, 108 F.2d 429, 430 (3d Cir. 1939) (securities are "substantially identical" for purposes of statutory wash sale rule where "differentiations (are) so slight as to be unreflected in the acquisitive and proprietary habits of holders of stocks and securities")) -- without offering any alternative point of reference. Moreover, the Fifth Circuit's rejection of a marketplace inquiry is difficult to square with its own statement that "fungible" goods are not materially different. See 887 F.2d at 586. Items are "fungible" if they are identical, but otherwise they can be reliably identified as "fungible" only if the relevant market treats them as fungible -- i.e., if the differences between the items are viewed by the market as wholly inconsequential. /15/ Indeed, were it not for the unwillingness of respondent and the other financial institutions involved in R-49 transactions to report this loss for financial and regulatory purposes, they could have obtained their desired tax losses simply by selling their depreciated mortgage loans for cash. In short, the purpose of the R-49 transactions was to allow the participants to have their cake and eat it too -- i.e., to produce paper losses that would be deductible for tax purposes, but that would not have to be reported for any other purpose. See note 2, supra. /16/ See Shoenberg v. Commissioner, 77 F.2d at 449 (where a sale of property "is made as part of a plan whereby substantially identical property is to be reacquired * * * the taxpayer has not actually changed his position"); Hanlin v. Commissioner, 108 F.2d at 430 (wash sales of "substantially identical" property described as resulting in "the lack of any change in economic position on the part of the taxpayer"). /17/ The government opposed the taxpayer's petition for certiorari in Colonial, noting that there was no conflict in the circuits. In our brief in opposition, we reported that the instant case was pending in the Fifth Circuit and stated that "(i)f a conflict in the circuits ever does develop on the question presented here, the Court can consider at that time whether certiorari is appropriate in those circumstances." No. 88-1003 Br. in Opp. at 4 n.3. /18/ The House Report on the 1939 legislation stated as its purpose to aid corporations "whose bonds can be purchased at the present time at less than their face value, giving them an incentive to liquidate their indebtedness." H.R. Rep. No. 855, 76th Cong., 1st Sess. 5 (1939). The Senate Report on the 1942 amendment explained that Congress had determined that limiting the availability of deferral to companies willing to declare their "unsound financial condition" had the effect of "deny(ing) the benefits of this section in many meritorious cases," and stated that removing that restriction "makes it possible for all corporations to have the advantages granted by this section without an impairment of their credit." S. Rep. No. 1631, 77th Cong., 2d Sess. 46, 78 (1942). See also 97 Cong. Rec. 3796 (1951) (statement of Rep. Camp) (provision "removes an impediment to strengthening the financial position of a corporation through debt reduction"). /19/ This method of payment was required not by the regulations that imposed the penalties, but rather by the terms of respondent's certificates. See Pltf. Exh. 26. /20/ The Solicitor General is disqualified in this case. APPENDIX