abused his discretion in requiring petitioner to adopt a different method of accounting for Valentine sales.

To reflect the foregoing, as well as concessions by the parties,

Decision will be entered under Rule 155.

THE PRUDENTIAL INSURANCE COMPANY OF AMERICA, PETITIONER v. COMMISSIONER OF INTERNAL

REVENUE, RESPONDENT

Docket No. 45430-85.

Filed January 11, 1988.

Petitioner, a mutual life insurance company, treated certain prepayment penalties attributable to its post-1954 corporate mortgage loans as long-term capital gain under sec. 1232, I.R.C. 1954, and, in computing its "gross investment income" under sec. 804(b), excluded those prepayment penalties from income described under sec. 804(b)(1)(C). Held, in computing its "gross investment income" under sec. 804(b), petitioner must include the prepayment penalties as income described under sec. 804(b)(1)(C), in each of the years at issue.

Michael F. Kelleher, for the petitioner.
Ellen Pilsecker, for the respondent.

OPINION

STERRETT, Chief Judge: By notice of deficiency dated September 26, 1985, respondent determined deficiencies of $6,954,469 and $6,910,113 in petitioner's Federal income taxes for calendar years 1972 and 1973, respectively. After concessions, the only issue for decision is whether petitioner, in computing its gross investment income under section 804(b),1 must include certain prepayment penalties attributable to its post-1954 corporate mortgage loans as income described under section 804(b)(1)(C).2

1Unless otherwise indicated, all section references are to the Internal Revenue Code of 1954 as amended and in effect during the taxable years at issue, and all Rule references are to the Tax Court Rules of Practice and Procedure.

"The sections discussed herein, sec. 804(b) and, infra, sec. 1232, were repealed for years ending Dec. 31, 1983, and July 18, 1984, respectively. Secs. 211(a)(1) and 42(a)(1), Deficit Reduction Act of 1984, 98 Stat. 720, 556.

The parties submitted this case on fully stipulated facts pursuant to Rule 122. The stipulation of facts and the exhibits attached thereto are incorporated herein by this reference.

Petitioner, the Prudential Insurance Co. of America, is a mutual life insurance company incorporated under the laws of the State of New Jersey. Petitioner had its principal office in Newark, New Jersey, when it filed its petition in this case, and timely filed its Federal income tax returns for the years at issue with the District Director in Newark, New Jersey.

As part of its investment activities, petitioner issued loans secured by mortgages on real property (mortgage loans) to corporate and noncorporate mortgagors. After issuance, petitioner retained these mortgage loans until retirement, rather than selling them to other financial institutions. Petitioner, however, generally permitted the mortgagors to prepay the mortgage loans and typically charged fees, known as "prepayment penalties," for any prepayments that exceeded specific percentage limitations.3 In its 1972 and 1973 Federal income tax returns, petitioner reported total prepayment penalties of $3,707,900 and $2,686,664, respectively. Petitioner treated the portion of the prepayment penalties that it derived from mortgage loans issued to corporations after December 31, 1954 (post-1954 corporate mortgage loans), as long-term capital gain under section 1232 and, in computing its gross investment incomé under section 804(b), excluded that portion from income described under section 804(b)(1)(C), in the amounts of $1,558,670 and $651,251 for 1972 and 1973, respectively.4

In his notice of deficiency, respondent determined that in computing petitioner's gross investment income under section 804(b), the prepayment penalties attributable to petitioner's post-1954 corporate mortgage loans were includable as income described under section 804(b)(1)(C). Correspond

'Petitioner typicallly used provisions in the mortgage loans to specify the terms of the prepayment penalties and charged the prepayment penalties in addition to any unpaid interest accrued to the date of prepayment.

*Correspondingly, petitioner computed its income described under sec. 804(b)(1)(C), as $2,149,230 and $2,035,413 for 1972 and 1973, respectively, representing prepayment penalties attributable to noncorporate mortgage loans and to corporate mortgage loans issued before Jan. 1, 1955.

ingly, respondent reduced petitioner's long-term capital gain and increased petitioner's income described under section 804(b)(1)(C) by $1,533,339 and $647,175 for 1972 and 1973, respectively.5

We must decide whether petitioner, in computing its gross investment income under section 804(b), must include the prepayment penalties at issue as income described under section 804(b)(1)(C). In general, life insurance companies are subject to tax based in part upon the computation of "gross investment income," a term defined under section 804(b) to include interest and other mortgage-related income. See secs. 802, 804. Specifically, prepayment penalties on mortgage loans are includable in computing "gross investment income" as income described under section 804(b)(1)(C). Indeed, under established case law, prepayment penalties on mortgage loans are includable in computing gross investment income because they constitute interest substitutes or additional fees for the use or forebearance of money. United Benefit Life Insurance Co. v. McCrory, 242 F. Supp. 845 (D. Neb. 1965), affd. 414 F.2d 928 (8th Cir. 1969); Equitable Life Assurance Society of the United States v. United States, 149 Ct. Cl. 316, 181 F. Supp. 241 (1960); see also General American Life Insurance Co. v. Commissioner, 25 T.C. 1265 (1956).

Apparently, petitioner does not contest respondent's determination that, in computing gross investment income, the provisions of section 804(b)(1)(C) apply, literally, to the

"These amounts represent the prepayment penalties that respondent determined as attributable to petitioner's post-1954 corporate mortgage loans. The parties stipulated, however, that the prepayment penalties at issue are $1,532,053, and not $1,533,339, for 1972. "The parties stipulated that petitioner qualified as a "life insurance company" under sec. 801(a) during the years at issue.

7Sec. 804(b) provides in pertinent part as follows:

SEC. 804(b). GROSS INVESTMENT INCOME-For purposes of this part, the term "gross investment income" means the sum of the following:

(1) INTEREST, ETC.-The gross amount of income from

(A) interest, dividends, rents, and royalties,

(B) the entering into of any lease, mortgage, or other instrument or agreement from which the life insurance company derives interest, rents, or royalties, and

(C) the alteration or termination of any instrument or agreement described in subparagraph (B).

For example, the regulations specifically provide that "gross investment income includes amounts received as a penalty for the early payment of a mortgage," language similar to that found in the legislative history to the Life Insurance Company Tax Act for 1955. Sec. 1.804-3(a)(1), Income Tax Regs.; see H. Rept. 1098, 84th Cong., 1st Sess. (1955), 1956-1 C.B. 954, 957; S. Rept. 1571, 84th Cong., 2d Sess. (1956), 1956-1 C.B. 967, 970.

prepayment penalties at issue. Instead, petitioner argues that, notwithstanding section 804(b)(1)(C), the prepayment penalties at issue qualify for long-term capital gain treatment under section 1232 because they represent gain on the retirement of corporate obligations issued after December 31, 1954.9 Petitioner asserts, therefore, that the prepayment penalties at issue are excludable from income described under section 804(b)(1)(C) by operation of the last sentence of section 804(b), which provides:

Except as provided in paragraph (2) [relating to the computation of the excess, if any, of net short-term capital gain over net long-term capital loss], incomputing gross investment income under this subsection, there shall be excluded any gain from the sale or exchange of a capital asset, and any gain considered as gain from the sale or exchange of a capital asset.

Respondent, on the other hand, argues that the prepayment penalties at issue do not qualify for long-term capital gain treatment under section 1232, but instead are includable as income described under section 804(b)(1)(C) in computing petitioner's gross investment income. Although petitioner presents meritorious arguments, we agree with respondent for the following reasons.

Upon the retirement of its mortgage loans, petitioner is not entitled to long-term capital gain treatment under section 1232 for amounts that represent ordinary income. United States v. Midland-Ross Corp., 381 U.S. 54, 56-57 (1965), and cases cited therein; see generally Williams v. McGowan, 152 F.2d 570 (2d Cir. 1945). As discussed above, prepayment penalties on mortgage loans in general constitute interest substitutes or additional mortgage loan fees and, therefore, constitute ordinary income. General American Life Insurance Co. v. Commissioner, supra at 1267; United Benefit Life Insurance Co. v. McCrory, 242 F. Supp. at 851; see generally Hort v. Commissioner, 313 U.S. 28 (1941). In the present case, the record contains no evidence indicating that the prepayment penalties at issue differ in

"In general, gain on the sale, exchange, or retirement of corporate debt obligations issued after Dec. 31, 1954, qualifies as long-term capital gain under sec. 1232 except to the extent of earned original issue discount. Sec. 1232(a)(1) and (a)(2). With respect to petitioner's argument, the parties stipulated that petitioner did not issue its post-1954 corporate mortgage loans at a discount. Specific portions of sec. 1232 relevant to petitioner's argument are set forth in the Appendix at page 43.

kind from those in the foregoing cases. A penalty is a penalty is a penalty. Accordingly, we must conclude that the prepayment penalties at issue constitute ordinary income and therefore do not qualify for long-term capital gain treatment under section 1232.

Petitioner asserts, however, that in general, prepayment penalties do not constitute ordinary income as interest substitutes, but instead constitute long-term capital gain because they provide compensation for lost capital appreciation in relation to mortgage loans without prepayment provisions.10 However, the record contains no evidence indicating that petitioner realized any capital appreciation on its post-1954 corporate mortgage loans, or indicating that petitioner inserted the prepayment provisions in its mortgage loans in order to receive compensation for lost capital appreciation.11 We can only conclude on the record before us, adversely to petitioner's assertion but consistently with the discussion above, that the prepayment penalties at issue simply constituted interest substitutes or additional mortgage loan fees to petitioner.

Petitioner further argues that several of the foregoing decisions are not controlling in the present case because they address provisions of the 1939 Code, rather than long-term capital gain considerations under section 1232 and the last sentence of section 804(b). See General American Life Insurance Co. v. Commissioner, supra; see also Prudential Insurance Co. of America v. United States, 162 Ct. Cl. 55, 319 F.2d 161 (1963). However, each of the foregoing decisions consistently holds that, with respect to the substance of the payments involved, prepayment penalties attributable to mortgage loans represent interest substitutes or additional mortgage loan fees and, consequently, constitute ordinary income. Compare, e.g., Equitable Life Assurance Society of the United States v. United States, 181 F. Supp. at 242-244, with Prudential Insurance Co. of America v. United States, 319 F.2d at 166-167. As dis

10With respect to this assertion, the parties stipulated to hypothetical market conditions in which the values of mortgage loans with no prepayment provisions typically increase when prevailing market interest rates decrease below the stated interest rates of those mortgage loans.

"To the contrary, the record indicates that petitioner held its mortgage loans to retirement, did not sell its mortgage loans to third parties, and inserted prepayment provisions in its mortgage loans to discourage prepayments during periods of falling interest rates.