Louis J. Kocurek and Millie M. Kocurek, Plaintiffs-appellants, v. United States of America, Defendant-appellee, 628 F.2d 906 (5th Cir. 1980)

This is a taxpayer's suit for a refund of income taxes paid. 28 U.S.C. § 1346(a) (1). The taxpayers appeal from denial of their refund. See Kocurek v. United States, 456 F. Supp. 740 (W.D.Texas, 1978).

Before us is an issue of first impression. It concerns the application and construction of several sections of the Internal Revenue Code of 1954, as amended, Subtitle A-26, Income Taxes, 26 U.S.C. §§ 1-1552. The issue involves the proper characterization of a distribution from a regulated investment company (popularly known as a "mutual fund"), sections 851-55, I.R.C., for purposes of determining the limitation on investment interest allowable as a deduction under section 163(d).

The taxpayers contend that a "capital gain dividend," section 852(b) (3) (C), distributed to a mutual's shareholders must be characterized as a "dividend," while the government contends that the "capital gain dividend" should be characterized as a "capital gain." Under the law then in effect, although either characterization had the effect of permitting the taxpayers to increase their allowable investment interest deduction,¹  a "capital gain"-to the extent it was used by the present taxpayers to increase their allowable investment interest deduction-was correlatively taxable at ordinary income (instead of capital gains) rates, section 163(d) (5) (1969).²  We agree with the district court that, under sections 163(d) and 852(b) (3) (B) of the Code, a "capital gain dividend" is more properly characterized as a "capital gain" than as a "dividend"; accordingly, we affirm the denial of the refund sought.

* The issue before us involves the interrelationship of the statutory language and legislative concepts and purposes of sections 163(d) (providing for limitations on the investment interest deduction), see II below, and 852(b) (allowing certain tax advantages to shareholders in mutual funds) of the Code, see III below. It also involves the taxpayers' contention that the general definition of a "dividend" provided by section 316(a), see IV below, was intended to include the "capital gain dividend", as defined by section 852(b) (3) (C) of the tax provisions relating to regulated investment companies ("mutual funds"). In general, the latter provisions permit a pass-through of net long-term gains to a shareholder (without corporate tax-liability), who is then statutorily entitled, section 852(b) (3) (B), to treat such distributions as a long-term capital gain rather than as ordinary income.

Before setting forth the statutory provisions and their relationship, we note the stipulated facts of this litigation:

The taxpayers used $43,298.00 (in 1973) and $79,963.00 (in 1974) of the capital gain dividends that they had received from regulated investment companies to increase the net investment income under section 163(d) (1) (B) for purposes of increasing the investment interest deduction allowed. The government disallowed these amounts under this section, its position being that the taxpayers were required to report them under section 163(d) (1) (C) as long-term capital gains, if the taxpayers chose to use these capital-gain amounts to increase their allowable investment interest deduction. Under section 163(d) (1) (C), these amounts became subject to an adjustment under section 163(d) (5) from capital-gain income to ordinary income, to the extent that such capital-gain income was used to increase the allowable investment interest deduction.

Because the taxpayers were required-if they elected to use the mutual funds distributions to increase their allowable investment interest deduction-to treat these capital gain dividends as long-term capital gains under section 163(d) (1) (C), their taxes were increased in the amount of $13,826.00 in 1973 and $17,895.00 in 1974, as compared to the amount due if their investment interest deduction was increased by the characterization of these capital-gain distributions as "dividends." This suit is for refund of these amounts.

II

The threshold issue involves a consideration of section 163(d), as enacted by the Tax Reform Act of 1969. In order to correct perceived abuses, the Congress enacted a limitation on interest previously deductible from gross income insofar as applicable to interest on investment indebtedness-i. e., "investment interest", or that "paid or accrued on indebtedness incurred or continued to purchase or carry property held for investment", section 163(d) (3) (D). As more explicitly stated below, in the computation of the allowable investment interest deduction, the taxpayer was permitted by the original enactment to increase it by the amounts of both "dividends", (d) (1) (B), (d) (3) (B), and "net long-term capital gains", (d) (1) (C), received or accrued during the tax year. However, to the extent that a taxpayer elected to use capital gains to increase his allowable investment interest deduction, he was likewise required (by way of a balancing adjustment) to forego favorable capital-gains treatment of the amounts so used by him. Section 163(d) (5).

As noted, the characterization of the "capital gain dividend", see III below, as a "capital gain" rather than as a "dividend" had favorable consequences for taxpayers receiving such distributions from mutual funds. These will be accentuated by a 1976 amendment to section 163(d), which was intended to bar the use of long-term capital gains for purposes of increasing the allowable investment interest deduction (see note 1 supra) .

Background

Section 163(a)³  allows a taxpayer to claim as a deduction the amount of interest he has paid during the year on indebtedness. In the Tax Reform Act of 1969,⁴  Congress placed a limitation on the amount of interest incurred solely for investment purposes which a taxpayer could deduct, enacted as section 163(d), I.R.C.⁵  The House Committee Report on section 163(d)⁶  evidenced its concern over taxpayers who voluntarily incurred substantial interest expenses on funds borrowed to acquire investment assets. It noted that

(w)here the interest expense exceeds the taxpayer's investment income, it, in effect, is used to insulate other income from taxation. For example, a taxpayer may borrow substantial amounts to purchase stocks which have growth potential but which return small dividends currently. Despite the fact that the receipt of the income from the investment may be postponed . . ., the taxpayer will receive a current deduction for the interest expense even though it is substantially in excess of the income from the investment.⁷ 

Congress sought to rectify the resultant mismatching of the investment income with the related expenses of earning that income, which occurred when the taxpayer was allowed a current deduction for interest and where the taxpayer's investment, however, produced little current income.⁸  The Congress addressed this perceived abuse by enacting 163(d), which limited the amount of investment interest allowable as a deduction.

Section 163(d)'s Application to the Present Facts

Section 163(d) sets forth the formula to be used in computing this limitation. Two factors are of particular importance to the instant case:1. Section 163(d) (1) (B)⁹  allows the interest limitation to be increased by the "net investment income." Net investment income is defined in 163(d) (3) (B) (i) as "the gross income from interest, dividends, rents, and royalties." (Italics supplied.); and,

2. Section 163(d) (1) (C)¹⁰  permitted the taxpayer to increase the amount of investment interest allowable as a deduction also by long-term capital gains he claimed for this purpose. However, if the taxpayer elected to use long-term capital gains for the purpose of increasing his allowable investment-interest deduction, Section 163(d) (5)¹¹  required as a counterbalancing adjustment that the amount so used should be treated as ordinary income.

The issue before us is whether, for purposes of increasing the investment interest deduction allowed by section 163(d), a "capital gain dividend," section 852(b) (3) (C), distributed to a mutual fund's shareholders is a "dividend" under 163(d) (1) (B) and (d) (3) (B) (i), or instead a "capital gain" under 163(d) (1) (B). Before addressing this issue, we must first look at the statutory context in the taxation of regulated investment companies ("mutual funds") in which this term is defined.

III

Sections 851-55 of the Internal Revenue Code of 1954 provide special rules for taxation of regulated investment companies often referred to as "mutual funds." The general concept was to encourage the pooling of investment funds by taxpayers; through its election to be taxed under these provisions, in general the corporation is taxed only on undistributed income, while the shareholders report the distributed income as ordinary income or capital gain, as the case may be. 7 Mertens, The Law of Federal Income Taxation, Chapter 41, §§ 41.01-.02 (1976 rev.) (hereinafter, "Mertens"); Bittker and Eustice, Federal Taxation, P 1.06 (4th ed. 1979); Rubin, Regulated Investment Companies, 28 Taxes 541 (1950). As summarized by the congressional committee reports concerning these special taxation features:

Regulated investment companies which meet various requirements with respect to asset diversification, capital structure and operations and which distribute at least 90 percent of their ordinary income are treated as conduits of income and taxed only on their undistributed income. Dividends paid by such companies are taxed in the usual manner to shareholders except that dividends arising from capital gains realized by the company are identified and receive capital gains treatment in the hands of the recipient. This method permits investors to pool their funds through the use of a corporation in order to obtain skilled, diversified investment in corporate securities without having to pay an additional layer of corporate tax. (Italics supplied.)

H.R.Rep., p. 4017 at 4099, and Sen.Rep., p. 4621 at 4734, on H.R. 8300 (Internal Revenue Code of 1954), as reprinted in (1954) 3 U.S.Code Cong. & Admin.News.

The issue before us involves the characterization as either "dividend" or else "capital gain," for purposes of section 163(d), of the "capital gain dividend" provided by these special mutual-funds taxing provisions.

The relevant provisions are: In the calculation of the corporate tax on its capital gains, the taxable amount is reduced by a dividend deduction determined by reference to the capital gain dividends paid to the shareholders. Section 852(b) (3) (A); Mertens, § 41.05. The 1954 Code further provided: "A capital gain dividend shall be treated by the shareholder as a gain from the sale or exchange of a capital asset held for more than 6 months,"¹²  section 852(b) (3) (B) (italics ours)-i. e., "capital gains realized by the regulated investment company are transferred to the stockholders for taxation purposes, to the extent that such capital gains are paid over to the stockholders as capital gains dividends," Mertens, § 41.06 at p. 41-7.

Section 852(b) (3) (C) defined a capital gain dividend as "any dividend or part thereof, which is designated by the company as a capital gain dividend in a written notice mailed to its shareholders not later than 30 days¹³  after the close of the taxable year." In the context of the statutory provisions previously cited, as well as of other mutual-funds taxing provisions,¹⁴  the "capital gain" dividend was a pass-through to the taxpayer of the corporation's long-term capital gain, as if the taxpayer himself had acquired and had sold the property upon which the capital gain was realized. Subject to taxation at the shareholder level only at capital-gains rates, section 852(b) (3) (B), the "capital gain dividend" was thus differentiated from the ordinary "dividend", as defined by section 316(a), which (with two specified exceptions¹⁵ ) were includable as defined in gross income and taxable at ordinary-income rates. Sections 301(a), 301(c) (1), and 61(a) (7); see, e. g., Bittker and Eustice, cited supra, PP 7.01, 7.02. (It was unnecessary for the Congress to include capital gain dividends as an additional exception to the 316(a) definition, in the context of the 1954 Code, because by a specific provision relating solely to them, section 852(b) (3) (B), the Code had elsewhere provided for non-dividend ("long-term capital gain") classification of a "capital gain dividend.")

The special taxation provisions for regulated investment companies contain an additional reference to the capital gain dividend. In our view (although the taxpayers draw an opposing inference), it likewise indicates the 1954 Code's legislative intent that the capital gain "dividend" is to be differentiated from the ordinary-income "dividend" defined by section 316(a). Section 854(a) provided: "Capital Gain Dividend.-For purposes of section 34(a) (relating to credit for dividends received by individuals, section 116 (relating to an exclusion for dividends received by individuals), and Section 243 (relating to deductions for dividends received by corporations), a capital gain dividend (as defined in Section 852(b) (3)) received from a regulated investment company shall not be considered as a dividend."¹⁶  Thus, in the context of the 1954 Code, the capital gain dividend was not only treated as a "capital gain" rather than a "dividend" for purposes of a capital-gain rate favorable to the taxpayer; it was also not treated as a "dividend" for purposes of deduction and exclusion treatment favorable to the shareholder that was afforded corporate dividends by the Code.

We therefore agree with the district court as to the legislative intent reflected with regard to the "capital gain dividend" as provided for by the special taxing regulation of the regulated investment companies (mutual funds) enacted as sections 851-55 of the Internal Revenue Code of 1954. This intent indicates that the "capital gain dividend" was intended to be treated as a "capital gain" and not as a "dividend" and that, in function and effect, a capital-gain-dividend was generically different from an ordinary-income-dividend. Although denoted as a "capital gain dividend," in its special context the term "dividend" so used did not have as its intended meaning or effect any of the tax consequences of a "dividend" as defined by section 316(a). Although under corporation law technically a "dividend" distribution, in actual fact for tax-law purposes the "capital gain dividend" was a non-taxable (at the corporation level) transfer to the taxpayer of the capital gain acquired by the investment corporation.¹⁷ IV

The issue before us involves Section 163(d), enacted by the Tax Reform Act of 1969, with its intended effect of limiting the deduction of investment interest. See II of opinion supra. In permitting a taxpayer to increase the allowable deduction, the legislation permitted both "dividends ", section 163(d) (1) (B), (d) (3) (B) (i), and "long-term capital gain " to be used, section 163(d) (1) (B). However, if the taxpayer elected to use a capital gain for this purpose, to the extent so used a capital gain was adjusted so as to be taxable at ordinary-income rates. Section 163(d) (5) (1969).¹⁸ 

The taxpayers argue that a "capital gain dividend" should be characterized for 163(d) purposes as a "dividend" instead of a capital "gain," despite the legislative provision specifically declaring that "(a) capital gain dividend shall be treated by the shareholders as a gain from the sale or exchange of a capital asset," Section 852(b) (3) (B) (italics supplied). The taxpayers not unpersuasively argue that a "dividend" is defined for all income tax purposes by section 316(a), except where specifically excluded from the "dividend" definition; and that the 316(a) definition includes within its literal terms a "capital gain dividend," a distribution from the corporation out of its current or prior earnings.¹⁹ 

We have previously determined, however, that, as used in sections 851-55 pertaining to special taxation regulation of mutual funds, the "capital gain dividend" was legislatively intended to be a "capital gain" transfer rather than a "dividend" in the tax sense. See III of opinion above.

The taxpayers forcefully argue that nevertheless a "capital gain dividend" should be characterized as a "dividend" as well as a "capital gain," (1) because section 316(a) excepted only two categories of dividends from its definition (and not, additionally, a "capital gain dividend"), and (2) because section 854(a) with specific reference to a "capital gain dividends" provides for only specific limited non-dividend effect to such a distribution. This contention essentially relies upon an inclusio-unius-est-exclusio-alterus argument (the inclusion of one is the exclusion of the other) to support a logical deduction of legislative intent that a "capital gain dividend" is to be considered a "dividend" for all purposes not by specific statutory provision excepted from the effects of being within the statutory definition. Previously, see III supra (text at notes 15 and 16), we have already noted why, in the context of the 1954 Code, an inference of such legislative intent should not be made: (1) it was not necessary for section 316(a) to specify that capital gains dividends were excluded from the definition of "dividends," since by providing that they be treated as capital gains, section 852(b) (3) (B), the Code had elsewhere functionally excepted them from the definition; and (2) section 854(a)'s provision for non-dividend effects of the "capital gain dividend", rather than indicating an intent that it be treated otherwise as a "dividend" for all other purposes, merely illustrated the statutory intent that a true capital-gain dividend be differentiated from an ordinary-income dividend.

Section 163(d), enacted in 1969 subsequent to the 1954 statutory classification of a capital gain dividend as a "capital gain" rather than as a "dividend," cannot be regarded in our opinion as intended to change this classification for income tax purposes. The legislative silence on the issue by itself permits a judicial inference that no change was intended. Further, the legislative history reflects no reason why a capital gains dividend, already affording a taxpayer extremely favorable tax treatment (see III supra), should be used to increase the allowable investment interest deduction without being subject to the same adjustment to ordinary-income treatment required of all other capital gains so used, at least in legislation specifically designed to limit the amount of investment interest allowable as a deduction (see II above). As the district court concluded, supra at 456 F. Supp. 743-44 (footnotes omitted):

Prior to the 1969 amendments there was no limitation on the amount of interest which a taxpayer could deduct, particularly for interest expenses on funds borrowed to acquire investment assets. Subsection (d) of section 163 was proposed to impose such a limitation. In explaining the operation of this limitation upon interest on investment indebtedness, the House Report stated that such ". . . interest which is in excess of $25,000 would first offset the amount of the taxpayer's net investment income taxed as ordinary income." H.R.Rep.No. 91-413, 91st Cong., 1st Sess., reprinted in (1969) U.S.Code Cong. & Admin.News, pp. 1645, 1718-1720 (emphasis added).²⁰  It was originally intended, therefore, that investment income taxable as ordinary income was to be classified separately from items taxable as capital gains. This amendment was deleted by the Senate and later reappeared in the conference substitute. Although the above quoted language was omitted from their report, the Conference Committee followed the House provisions as modified. Cong.Rep.No. 91-782, 91st Cong., 1st Sess., reprinted in (1969) U.S.Code Cong. & Admin.News, pp. 2392, 2414-2415.

Finally, additional support for the government's position can be drawn from an analysis of the minimum tax on tax preference items which was also included as a part of the Tax Reform Act of 1969. Section 163(d) (5) makes reference to the minimum tax on capital gains which are included as a tax preference item by section 57(a) (9). The proposed Treasury Regulations provide that capital gain dividends are to be included as a tax preference item. The Senate Report explains that shareholders are to be subject to minimum tax for those capital gains items which are passed through the corporation to them. S.Rep.No. 91-552, 91st Cong., 1st Sess., reprinted in (1969) U.S.Code Cong. & Admin.News, pp. 2027, 2148. For purposes of the minimum tax, therefore, capital gain dividends are to be treated as capital gains, which are included as a tax preference item by section 57(a) (9) (A). Any apparent ambiguity in section 163(d) is thus dispelled.

After having thoroughly reviewed the relevant statutory provisions and the pertinent portions of the legislative history of the Tax Reform Act of 1969, it is the opinion of this Court that the taxpayers are required under the Code to treat capital gain dividends as capital gains for the purpose of section 163(d), in the same manner that they are required to treat them elsewhere.

Conclusion

For the reasons assigned, we find that the capital gain dividend to shareholders by a regulated investment company, sections 851-55, which section 852(b) (3) (B) provides shall be treated by the shareholders as a capital gain, cannot be treated as a "dividend" for purposes of increasing the allowable investment deduction under section 163(d) (1) (B), (d) (3) (B) (i), if claimed for such purpose. Accordingly, we AFFIRM the district court judgment rejecting the taxpayers' suit for refund of income taxes.

FAY, Circuit Judge, concurring:

While concurring in Judge Tate's opinion for the court, I add this thought. Taxpayers should not have to "guess" at the meanings of statutory definitions. Prior to this opinion there is no way a reasonably prudent taxpayer could have anticipated this result unless he or she assumed Congress did not mean what it said. Such a situation is wrong and only highlights the need for improved draftmanship by all of those involved. Taxation need not and should not remain a mystery,¹  or worse, a trap.