Rev. Rul. 55-389

Advice has been requested whether interest paid or accrued on debentures sold by a corporation to increase its working capital and to provide for refunding of indebtedness, and plant expansion, constitutes an allowable deduction within the meaning of section 23(b) of the Internal Revenue Code of 1939 where a substantial portion of the proceeds of the indebtedness is temporarily invested in tax-exempt securities.

A sharp growth in sales volume and rapidly increasing demands on taxpayer's manufacturing facilities, as well as a material increase in its working capital requirements, necessitated an additional financing program. In this connection the taxpayer issued additional capital stock and sinking fund debentures. Through this financing the taxpayer proposed to provide additional capital for additional equipment, facilities and related services to manufacture its products. The taxpayer also proposed to liquidate some of its debts. The balance of the monies received through this financing program was to be used for working capital and other corporate purposes.

The sale of the additional shares of stock and sinking fund debentures was consummated in April 1954, and a portion of the proceeds was applied for purposes of liquidating the taxpayer's debts, leaving a net balance for the purpose of planned expansion and working capital.

The taxpayer, being aware of the time required to complete the performance of construction contracts and to obtain delivery of machine tools, invested a substantial portion of the proceeds from the sales of debentures for a short but unspecified period of time in taxexempt negotiable securities.

Section 23 of the 1939 Code provides that in computing net income there shall be allowed as deductions:

(b) INTEREST.-All interest paid or accrued within the taxable year on indebtedness, except on indebtedness incurred on continued to purchase or carry obligations (other than obligations of the United States issued after September 24, 1917, and originally subscribed for by the taxpayer) the interest upon which is wholly exempt from the taxes imposed by this chapter.

The indebtedness in question has been incurred for the purposes of refinancing other indebtedness, furnishing working capital, and contemplated plant expansion, rather than `to purchase or carry' taxexempt securities. Accordingly if the borrowed funds so invested in the tax-exempt securities are expended for plant expansion during the years 1954 and 1955, it is held that the interest paid or accrued on the debentures will constitute an allowable deduction under section 23(b) of the Code, notwithstanding the temporary investment of such funds in tax-exempt securities. Compare S.R. 5128, C.B. IV-2, 156 (1925)