Rev. Rul. 69-243

Advice has been requested regarding the application of section 1.163-3 of the Income Tax Regulations, as added by Treasury Decision 6984, approved December 19, 1968, page 38, this Bulletin, to a repurchase of convertible bonds under the circumstances described below.

On March 24, 1964, X corporation issued at par 5 percent subordinated convertible debentures each in the face amount of $100 due on March 17, 1974. The debentures were convertible, at the holder's option, at any time on or before the date fixed for redemption, into two shares of the common stock of X. Under the terms of the bond, X reserved the right to call the debentures at decreasing prices beginning at 105 percent of face value up to March 17, 1969, and diminishing to 100 percent after September 17, 1973. On December 18, 1968, X repurchased all of the debentures for $167 each. On that date, each share of the common stock of X had a fair market value of $83.50.

Section 1.163-3(c)(1) of the regulations provides in pertinent part, except as provided in section (c)(2) thereof, that if bonds are issued by a corporation at face value and are subsequently repurchased by the corporation at a price in excess of the issue price "the excess of the purchase price over the issue price * * * is a deductible expense for the taxable year." Prior to amendment by Treasury Decision 6984, section 1.61-12(c)(1) of the regulations provided in pertinent part, in respect of bonds issued at face value, that, "If the corporation purchases any of such bonds at a price in excess of the issuing price or face value, the excess of the purchase price over the issuing price or face value is a deductible expense for the taxable year."

Section 1.163-3(c)(2) of the regulations provides in pertinent part, that in the case of a convertible bond "except a bond which the corporation, before September 5, 1968, has obligated itself to repurchase at a specified price," the deduction allowable under section 1.163-3(c)(1) may not exceed an amount equal to one year's interest at the rate specified in the bond, except to the extent that the corporation can demonstrate to the satisfaction of the Commissioner or his delegate that an amount in excess of one year's interest does not include any amount attributable to the conversion feature.

In determining whether section 1.163-3(c)(1) or 1.163-3(c)(2) of the regulations is applicable to determine the deductibility of premium paid on a repurchase of convertible bonds, the test is whether the issuing corporation has obligated itself, prior to September 5, 1968, to repurchase the bonds at a specified price. Thus, the provisions of section 1.163-3(c)(1) are applicable in any case in which a corporation has issued convertible bonds which it has obligated itself to repurchase at a specified price prior to September 5, 1968.

In the instant case, since X obligated itself, prior to September 5, 1968, to repurchase its convertible bonds at a specified price, after call, the deductibility of the premium paid on repurchase must be tested under the provisions of section 1.163-3(c)(1). These provisions are substantially the same as the provisions that were contained in section 1.61-12(c) of the regulations prior to amendment of the latter by T.D. 6984.

In Revenue Ruling 67-409, C.B. 1967-2, 62, the Service announced that it would not follow the decision of the United States Court of Appeals for the Seventh Circuit in Roberts & Porter, Inc. v. Commissioner, 307 F. 2d 745 (1962), reversing 37 T.C. 23 (1961), acquiescence, C.B. 1962-2, 5, which held that the premiums paid by the taxpayer on the purchase of its callable convertible notes in excess of the amounts for which it was legally bound to pay upon calling the notes constituted ordinary and necessary business expenses under section 162 of the Internal Revenue Code of 1954 and section 1.61-12 of the regulations before amendment by T.D. 6984. In that case the position of the Service was that such excess amounts are not deductible. The longstanding position of the Service has been that a deduction for premiums paid by a corporation on the redemption or repurchase of its own bonds, under the provisions of these sections or any other sections of the Code or regulations is limited to an amount which relates to the cost of borrowing money and, thus, such excess amounts are not deductible.

Accordingly, under the facts of the instant case, the amount deductible by X on repurchase of each debenture is limited to $5, the amount of the call premium specified in each debenture which is related to the cost of borrowing. The excess amount paid on repurchase of each debenture, $62, that is, $67 minus $5, is not deductible since X was under no legal obligation to pay such amount and it does not relate to the cost of borrowing money, but in fact represents an expenditure by X to preclude conversion of the bonds into its common stock.

¹ Also released as Technical Information Release 1012, dated April 24, 1969.