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October 17, 1972


The opinion of the court was delivered by: Marovitz, District Judge.


This is an action by Danly Machine Corporation, a manufacturer of die sets and punch presses, seeking a refund of $105,365.55 in allegedly overpayed Federal income taxes. The case is presently before this Court for partial trial based upon a written stipulation of all uncontested facts and separate statements by each party regarding contested issues of law not agreed to.

The debate centers around what treatment ought to be given under Internal Revenue Code, § 163 for original issue bond discount paid on an investment unit consisting of an obligation and an option for tax years prior to 1968.

The pertinent facts follow. During its fiscal year ended June 30, 1956, the taxpayer issued a total of $1,000,000 of 6% subordinated debentures to three insurance companies. The debentures, in the amount of $500,000, $250,000 and $250,000, respectively, were payable in semi-annual installments each year from 1956 through 1970. The money market being what it was and the fact that Danly was already quite heavily indebted precipitated an arrangement whereby as an inducement to the insurance companies to loan the $1,000,000, the taxpayer was also required to issue to the insurance companies options to purchase a total of 30,000 shares of the taxpayer's common stock at predetermined prices. The issuance of these options enabled the taxpayer to avoid paying the higher interest rates demanded by potential lenders on subordinated debt without options. The taxpayer issued warrants during its fiscal year ended June 30, 1958, to the holders of the 6% subordinated debentures in lieu of the options originally given them. The warrants were for the purchase of 30,000 shares of the taxpayer's common stock at predetermined prices at any time up to January 18, 1966. The warrants were substituted for the options as a part of certain negotiated amendments in the terms of the 6% subordinated debentures. The taxpayer made the final installment payments on the 6% subordinated debentures during its fiscal year ended June 30, 1966. In January 1965, the warrant holders elected to exercise their option and requested the taxpayer to either redeem the warrants or register the 30,000 shares of stock for public offering. Taxpayer elected to redeem these warrants at a negotiated price of $7.75 per share. The market bid price for the taxpayer's stock at the time of negotiation was $16 per share. The total cost for the redemption of the warrants amounted to $232,500. This amount was treated by the taxpayer as a special charge against its retained earnings account and not as an expense for accounting purposes. In its 1965 Annual Report to its shareholders, the taxpayer explained that by retiring the warrants, the taxpayer was avoiding the dilution of shareholders' equity and the payment of dividends which at the then annual rate of $1 per share amounted to $30,000 per year. The warrants were described in the equity section of the taxpayer's balance sheet. The subordinated debentures were described in the section of taxpayer's balance sheet where long-term debt was recorded. The taxpayer did not claim any deduction on its income tax return for the year ended June 30, 1965, as filed, for the amount paid to redeem the warrants nor did it claim any amortizable bond discount on its income tax returns filed for its fiscal years ended June 30, 1956 through June 30, 1966, the date of the debenture retirement. On September 22, 1967, the taxpayer timely filed a claim for refund of tax in the amount of $113,944.12, for its fiscal year ended June 30, 1965. On June 12, 1968, the Internal Revenue Service disallowed the claim for refund in full. On September 12, 1968, the taxpayer filed a protest to the disallowance by the Internal Revenue Service of the claim for refund. Upon reconsideration of the taxpayer's claim for refund, the Internal Revenue Service allowed a refund of tax in the amount of $4,199.94 for the fiscal year ended June 30, 1965 and $4,378.63 for the fiscal year ended June 30, 1966. On October 21, 1969, the Internal Revenue Service mailed to the taxpayer by certified mail notice of disallowance of the balance of the taxpayer's claim for refund. The taxpayer timely filed this suit for refund of federal income tax in the sum of $105,365.55, representing the balance of the disallowed claim for refund.

The taxpayer seeks a determination of whether it is entitled to a deduction for the fair market value of the warrants redeemed, under Internal Revenue Code § 163, for its 1965 tax year and whether the total amount of original issue bond discount which the taxpayer had not previously deducted could be deducted for its 1965 tax year. It bases its contentions on both its interpretation of Treasury Regulation § 1.163-3 and on the general argument that the expense of warrant redemption incurred as part of an investment unit consisting of an indebtedness and an option is proper original issue bond discount and thus an interest cost under § 163. It is an interest expense, Danly asserts, sanctioned by Treasury Regulations. The Government challenges these contentions on both procedural and substantive grounds arguing that the deduction was not § 163 interest and challenging this Court's jurisdiction on the grounds that plaintiff's present basis for a refund varies substantially from its original claim.

Though the general history regarding Danly's indebtedness is plain on its face, the grounds upon which plaintiff seeks a refund does indeed follow a more checkered chronology and in view of defendant's contention of `variance', warrants some elaboration.

Danly's original Form 843 claim for a refund filed on September 22, 1967 sought "a deduction as an ordinary and necessary business expense under § 162 of the Internal Revenue Code of 1954 as amended, payments made with respect to the retirement of debt." This theory was rejected. Danly then filed a protest abandoning its § 162 contentions and arguing instead that the stock warrants were an integral interest cost incurred as part of the indebtedness and their redemption was therefore deductible interest under § 163(a) of the Internal Revenue Code. This theory was likewise rejected. Though still claiming a refund under § 163, plaintiff's contentions seem to be somewhat different as we go to trial.

Plaintiff now claims that the redemption of the warrants was original issue bond discount paid on an investment unit consisting of an obligation and an option. In its first argument (P. 3 — Plaintiff's Supporting Brief) Plaintiff seeks to have Treasury Regulation § 1.163-3, which allows for investment unit deductions, applied retroactively so that the relief provided therein would apply to its claims.

The regulation clearly states that it applies prospectively only for taxable years ending on or after December 24, 1968 and only for the remaining life of the bonds (although it applies to obligations and options issued between December 31, 1954 and December 24, 1968). Plaintiff challenges the prospective application of this regulation as an abuse of the Commissioners power and would have us apply it retroactively thereby including its claims as well.

In its second argument (P. 8) Plaintiff claims that irrespective of whether Treasury Regulation § 1.163-3 is applied retroactively or prospectively it is entitled to a deduction for its 1965 taxable year for the fair market value of the warrants redeemed since it is a § 163 interest cost sanctioned by the Treasury. It finds this sanction in Treasury Regulation § 1.163-3(a)(2)(iii). Plaintiff argues that Paragraph (a)(2)(iii) plus Example 6 in that Section indicates that the deduction of fair market value for exercise of options in an investment unit can be deducted in years prior to 1968 and that such a deduction would be left undisturbed by Internal Revenue.

We will deal with the substantive merits of these contentions subsequently and we note them here simply for the jurisdictional questions raised by defendants.

The Government claims that this Court has no jurisdiction to hear plaintiff's claim since its present claim varies considerably from the claim it originally filed with the Internal Revenue. The Government concedes that plaintiff's second contention, (that irrespective of Treasury Regulation § 1.163-3's prospective application Example 6 therein sanctions a deduction as interest for exercised warrants) does not so substantially vary from its original claim to warrant a finding of lack of jurisdiction and abandons its jurisdictional argument as to that argument. The Government's concession in this respect is warranted. In its protest, plaintiff claimed the redemption of the warrants as a plain § 163 interest cost. In its Memorandum in this action plaintiff merely reasserts this contention based on new found information. Plaintiff still argues that the deduction is § 163 interest though in the form of original issue bond discount and in fact the partial refund made by the Government was based upon its own computation of original issue discount. Thus plaintiff's usage of § 1.163-3(a)(2)(iii) and Example 6 in its second argument is merely used to indicate that the Government sanctions such a deduction prior to 1968. More importantly, defendants have agreed that they were apprised of the argument that the regulation authorized the deduction. The claim having been previously raised we find that jurisdiction exists as to the second claim.

Plaintiff's first argument, however, presents a more difficult problem. It is quite clear that at no time prior to this action did plaintiff claim that § 1.163-3 should be applied retroactively. What remains for us to decide jurisdictionally is whether that contention varies so substantially from the original claim as to render it fatally flawed.

It has been clearly established that a taxpayer cannot advance one ground for refund in his filed claim and then rely upon an entirely different ground in a subsequent suit, a point which plaintiff concedes. Carmack et al. v. Scotfield, 201 F.2d 360 (5th Cir. 1953). The purpose of this rule is to fully apprise the Commissioner of the grounds for the taxpayer's claim so that he may make a proper decision and to narrow the issues involved.

This information can be presented through various sources other than the original claim filed, such as affidavits, statements, conferences and negotiations so long as the end result is the presentation of the full amount of information available and the narrowing of the controversy. United States v. Pierotti, 154 F.2d 758 (9th Cir. 1946); Clark v. United States, 143 F. Supp. 165 (D.C. 1956).

In view of the foregoing plaintiff argues that there was no variance between the theory or "scope" of its claim as evolved from its written protest and subsequent negotiations and its current argument that § 1.163-3 should be applied retroactively. It contends that the Government was fully apprised of the fact that it sought a deduction of the warrant redemption as § 163 original issue bond discount since it based its partial refund on that ground and the fact that the retroactive argument in regard to Treasury Regulation § 1.163-3 was not specifically raised is irrelevant since the Government knew of § 1.163-3's existence and should not be able to now plead ignorance in that respect.

The Government on the other hand contends that the Commissioner may insist on strict compliance with the rule that all grounds must be set forth in a single administrative claim. Indeed the Supreme Court in Angelus Milling Co. v. Commissioner, 325 U.S. 293, at ...

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