On Appeal from a Decision of the United States Tax Court-Washington, D.C. Tax Court No. 45430-85
Gibbons, Chief Judge, Hutchinson, Circuit Judge and Wolin, District Judge*fn*
The Prudential Insurance Company of America appeals from an adverse United States Tax Court decision. The sole issue presented is whether receipt by an insurance company of prepayment charges upon the retirement of certain corporate mortgages should be characterized as long-term capital gain excluded from "gross investment income" within the meaning of section 804(b) of the Internal Revenue Code. The Tax Court held that the prepayment charges should not be characterized as capital gain and therefore should not be excluded from "gross investment income." We will reverse the Tax Court's determination.
All of the relevant facts have been stipulated. The Prudential Insurance Company of America, taxpayer, is a mutual life insurance company incorporated under the laws of the State of New Jersey. It timely filed its federal income tax returns for 1972 and 1973, the years in issue, with the District Director in Newark.
The controversy revolves around loans made by the taxpayer. As part of its regular investment activities, the taxpayer made mortgage loans secured by real property to corporate and noncorporate borrowers. These mortgages generally contained provisions allowing the borrowers to prepay the obligations prior to the scheduled maturity dates if the borrowers agreed to also pay a specified amount in excess of the loan principal ("prepayment charge") plus any unpaid interest accrued to the date of retirement of the obligation.
The loans at issue were not made by the taxpayer at an amount above (premium) or below (discount) their principal amount. They were not issued with an intention to redeem the obligations prior to maturity. The taxpayer was not a dealer in corporate mortgages. The prepayment charges were normally specified in advance of the issuance of the mortgage, but in some cases, the prepayment charges were negotiated between the taxpayer and the debtor immediately prior to the retirement of the loan. Typically, the prepayment charges on the mortgage obligations were fixed on a sliding scale that decreased over time.
On its federal income tax returns for 1972 and 1973, the taxpayer treated the gain from prepayment charges on corporate mortgages issued after December 31, 1954, and held for more than six months as long term capital gain as defined in Code Section 1232(a)*fn1 and as such, excluded these amounts from "gross investment income" under section 804(b). The taxpayer conceded that the prepayment charges on mortgage loans to noncorporate borrowers or the prepayment charges on any mortgage made before January 1, 1955 should be treated as "gross investment income" under section 804(b).
Upon audit, the Internal Revenue Commissioner disagreed with the contention that prepayment penalties on corporate mortgages may be treated as long-term capital gain and excluded from gross investment income under section 804(b). The Commissioner issued an income tax deficiency notice based upon the treatment of all mortgage prepayment penalties as gross investment income. The taxpayer filed a petition with the Tax Court for review of his determinations.
The Tax Court upheld the Commissioner's deficiency determination. Payments which are in reality interest substitutes or equivalents, do not receive capital gain treatment. See United States v. Midland-Ross Corporation, 381 U.S. 54, 14 L. Ed. 2d 214, 85 S. Ct. 1308 (1965) (earned original issue discounts are interest equivalents, not capital gains). Following the General American line of precedent,*fn2 the Tax Court determined that prepayment charges constitute interest substitutes or additional fees for the use or forbearance of money. We disagree.
II. PREPAYMENT CHARGES ON CORPORATE MORTGAGES REPRESENT CAPITAL APPRECIATION NOT INTEREST
The reasoning underlying the Tax Court's decision and the precedents which it relied upon*fn3 is that the prepayment charge for the early retirement of a mortgage is additional interest to make up the higher interest charge which is generally charged on short-term as opposed to long-term obligations. Thus, the treatment of prepayment charges as interest equivalents depends upon the misconception that interest rates on short-term mortgages are higher than interest rates on long-term mortgages.
In reality, the converse is true. Interest rates on long-term obligations are generally higher than interest rates on short-term obligations. A lender will generally charge his cost of capital plus a premium for use of the money. The premium is directly related to the risk involved in making the loan which, all other factors being equal, is less in the shorter period. Financial solvency is easier to predict over shorter periods. The lender's cost of capital is also more easily predicted over a shorter period of time. Short-term obligations are more liquid than long-term obligations because by definition, the capital is committed for a shorter period. These factors combine to create higher interest rates on longer-term obligations.
The Tax Court held that prepayment charges are additional interest charges paid because the borrower shortened the term of the loan and shorter term loans have higher interest rates. The Tax Court's decision is in direct conflict with the stipulations entered into by the Commissioner of the Internal Revenue Service and the taxpayer. Stipulation 50 reads: "Historically, it has been most common for long-term interest rates to exceed short-term interest rates" (A. 34).
In the present case, the stipulations not only provide the facts that this court must accept but they also provide a review of financial theory necessary to understanding the operation of prepayment charges:
42. All other things being constant, the price at which a debt instrument with a fixed rate of interest may be purchased will rise and fall as the prevailing level of interest rates fluctuates. The price will increase when interest rates on instruments of similar credit risks decline. The price will decline when interest rates on instruments of similar credit risks increase. The price changes will be more pronounced if the debt instrument has no prepayment privilege.
43. The hypothetical Debt Instrument, which is the subject of paragraphs 44 through 47, has the ...