Rev. Rul. 74-210

The Internal Revenue Service has reconsidered its position with respect to the deductibility of premiums paid by a taxpayer on the repurchase of its callable convertible notes in excess of the amounts which it was legally obligated to pay upon the call of such notes.

In Rev. Rul. 67-409, 1967-2 C.B. 62, the Service announced that it would not follow the decision of the Seventh Circuit Court of Appeals in Roberts & Porter, Inc. v. Commissioner, 307 F.2d 745 (7th Cir. 1962). In Roberts & Porter, Inc., the court held that the premiums paid by the taxpayer on the purchase of its callable convertible notes in excess of the amounts which it was legally obligated to pay upon calling the notes constituted ordinary and necessary business expenses within the meaning of section 162 of the Internal Revenue Code of 1954, and section 1.61-12 of the Income Tax Regulations prior to its amendment by T.D. 6984, 1969-1 C.B. 38. The Service had argued in that case that such excess amounts were not deductible. The reason for the redemption was to keep the notes from being converted into stock with the possible sale of the stock to outsiders. The price was equivalent to the value of the stock into which the notes could be converted.

In Rev. Rul. 69-243, 1969-1 C.B. 56, the Service reiterated the position taken in Rev. Rul. 67-409, and held, under section 1.163-3 of the regulations as added by T.D. 6984, above, that a corporation which entered into an agreement to repurchase its callable convertible debentures at a specified price may not, upon repurchase of such bonds or debentures at a greater price, deduct any amount paid in excess of the call premium specified in each bond or debenture. Thus, under these Revenue Rulings a deduction for premiums paid by a corporation on the redemption or repurchase of its own bonds or similar evidence of indebtedness is limited to an amount which relates to the cost of borrowing money. Therefore, amounts paid in excess of such costs were regarded as being nondeductible expenditures.

However, in Head Ski Co. v. United States, 323 F. Supp. 1383 (D. Md. 1971), aff'd per curiam, 454 F.2d 732 (4th Cir. 1972), and Southwest Grease & Oil v. United States, 308 F. Supp. 107 (D. Kan. 1969), aff'd per curiam, 435 F.2d 675 (10th Cir. 1971), the courts rejected the rationale of Rev. Rul. 67-409 and Rev. Rul. 69-243, and held, following the Roberts & Porter, Inc. decision, that taxpayers could deduct the excess costs of repurchasing callable convertible evidences of indebtedness as ordinary and necessary business expenses. In all of these decisions the price paid was geared to the value of the stock into which the evidences of indebtedness could be converted.

In Head Ski Co., the convertible note was sold in 1963. The note required that Head Ski Co. pay interest quarterly, allowed no prepayment until April 30, 1968, and required the entire principal to be paid by May 1, 1973. In 1964, prior to any prepayment date, management decided that it was in the best interest of the company to pay off the convertible note. The price paid was an amount between the then bid price and the asking price of the shares of stock into which the note could be converted.

In Southwest Grease & Oil Co., the corporation issued convertible debentures on February 15, 1958, due February 15, 1973. After February 15, 1960, they were subject to redemption, upon 30 days notice. However, if called for redemption, the securities could be converted to stock up to the actual date of redemption. Since the corporation had no stock registered with the SEC to honor the conversion privilege and, upon consideration of the costs involved in such registration, and other factors, the corporation, in 1961, determined to redeem the debentures. The amount paid upon redemption was equal to the then value of the stock into which the debentures could be converted.

In view of these decisions, the Service will no longer adhere to the position set forth in Rev. Rul. 67-409 and Rev. Rul. 69-243.

Section 414 of the Tax Reform Act of 1969 (Act), Pub. L. 91-172, 1969-3 C.B. 10, 83, added section 249 to the Internal Revenue Code. Section 249 of the Code provides, in general, that no deduction shall be allowed to the issuing corporation for any premiums paid or incurred upon the repurchase of a bond, debenture, note, or certificate, or other evidence of indebtedness which is convertible into the stock of the issuing corporation, to the extent the repurchase price exceeds an amount equal to the adjusted issue price plus a normal call premium on bonds or other evidence of indebtedness which are not convertible.

Section 414(c) of the Act provides that section 249 of the Code shall apply to a convertible bond or other evidence of indebtedness repurchased after April 22, 1969, other than such a bond or other evidence of indebtedness repurchased pursuant to a binding obligation incurred on or before April 22, 1969, to repurchase such bond or other evidence of indebtedness at a specified call premium.

In Head Ski Co., the court noted that section 249 of the Code, as enacted, specifically covers deduction for premiums paid for the redemption of convertible notes. The court observed that Congress was aware of the court cases construing section 1.61-12(c)(1) of the regulations in a manner contrary to the position of the Internal Revenue Service and that the intention of Congress was to enact legislation to change the law prospectively.

In the case of repurchase of such evidences of indebtedness which do not come within the ambit of section 249 of the Code, amounts expended by taxpayers on the call of convertible evidences of indebtedness will be deductible under the rationale of the Roberts & Porter, Inc., Head Ski Co., and Southwest Grease & Oil Co. decisions, as long as taxpayers can show facts substantially similar to those in the cited cases. But see United States v. Haskel Engineering & Supply Co., 380 F.2d 786 (9th Cir. 1967), where the court disallowed the corporate taxpayer a deduction under either section 162 or section 163 of the Code for premiums paid, on a pro rata basis, to the corporation's only two shareholders for redemption of bonds held by the shareholders because the premiums paid were unreasonable in amount. The case did not involve convertible bonds. The Service will continue to follow the Haskel Engineering & Supply Co. decision in cases involving similar questions.

Rev. Rul. 67-409 and Rev. Rul. 69-243 are hereby revoked.