## Facts

- Prudential Insurance Company of America, a mutual life insurance company, invested in mortgage loans secured by real property, including mortgages to corporate borrowers.
- The mortgages were originated at par and were not issued with an intent to be redeemed before maturity.
- Prudential was an investor, not a dealer, in corporate mortgages.
- The mortgage contracts generally allowed early repayment if the borrower paid: principal, accrued interest to the payoff date, and a prepayment charge (a specified amount above principal) that was set in advance or sometimes negotiated at payoff.
- Prudential received prepayment charges on certain corporate mortgages in tax years 1972 and 1973.
- Prudential reported the prepayment charges as long-term capital gains and excluded them from “gross investment income” for life insurance companies under IRC § 804(b).

## Issues

1. Whether prepayment charges received on early retirement of corporate mortgages are long-term capital gains under IRC § 1232 (amounts realized on retirement treated as a sale or exchange).
2. Whether such prepayment charges must instead be treated as interest or “interest substitutes” includible in a life insurance company’s “gross investment income” under IRC § 804(b).

## Decision

- The Third Circuit reversed the Tax Court.
- The court held the prepayment charges were properly characterized as long-term capital gains under IRC § 1232.
- Because they were capital gains, the amounts were excluded from “gross investment income” under IRC § 804(b).
- The court rejected the Tax Court’s “interest substitute” characterization, concluding the charges reflected realized value tied to the obligation’s early retirement, not compensation for the period-by-period use of money.

## Legal Principles

- Under IRC § 1232, amounts received on the retirement of certain corporate debt obligations may be treated as amounts realized in a sale or exchange, permitting capital-gain treatment.
- A contractual payment required to retire a corporate debt obligation before maturity can be characterized as consideration for early termination (akin to a call premium) rather than interest, when it compensates the lender for loss of the instrument’s appreciated value due to changes in market rates.
- For life insurance companies, IRC § 804(b) excludes long-term capital gains from “gross investment income,” so amounts properly treated as capital gains are not included in that base.
- A payment is not “interest” merely because it is triggered by prepayment; the characterization turns on the payment’s function—whether it compensates for use/forbearance of money over time (interest) or for the value surrendered by early retirement (capital amount).

## Conclusion

The Third Circuit held that corporate-mortgage prepayment charges received by a life insurance company upon early retirement of the loans were long-term capital gains under IRC § 1232, analogous to call premiums, and therefore were excluded from “gross investment income” under IRC § 804(b).


Prudential Ins. Co. of Am. v. Comm’r of Internal Revenue, 882 F.2d 832 (3d Cir. 1989)