Korell v. Comm'r of Internal Revenue, Docket No. 13943.
| Decision Date | 02 June 1948 |
| Docket Number | Docket No. 13943. |
| Citation | 10 T.C. 1001 |
| Parties | CHRISTIAN W. KORELL, PETITIONER, v. COMMISSIONER OF INTERNAL REVENUE, RESPONDENT. |
| Court | U.S. Tax Court |
OPINION TEXT STARTS HERE
Premium paid for bonds callable for redemption on 30 days' notice held amortizable in full in year of acquisition under Internal Revenue Code, sections 23(v) and 125, notwithstanding premium may have been due entirely to accompanying privilege of converting into obligor's stock at price below current market. Paul L. Peyton, Esq., for the petitioner.
Ellyne E. Strickland, Esq., for the respondent.
This proceeding was brought for a redetermination of a deficiency in income tax for the year 1944 in the amount of $5,218.84. Minor adjustments have been conceded by petitioner and the litigated issue is whether respondent erred in disallowing the deduction claimed by petitioner in the taxable year under Internal Revenue Code, sections 23(b) and 125, as amortization of the premium over the call price of certain bonds.
FINDINGS OF FACT.
All the facts are stipulated and are hereby found accordingly.
Petitioner, an individual, filed his income tax return for the period in question with the collector of internal revenue for the second district of New York.
During 1944 petitioner purchased $50,000 principal amount of american Telephone & Telegraph Co. 15-year 3 per cent convertible debenture bonds, due September 1, 1956, as follows:
+----------------------------------------------+
¦August 16, 1944, $11,000 at 121 1/8¦$13,351.25¦
+-----------------------------------+----------¦
¦August 16, 1944, $2,000 at 121 ¦2,425.00 ¦
+-----------------------------------+----------¦
¦August 22, 1944, $37,000 at 121 1/4¦44,862.50 ¦
+----------------------------------------------+
The average market price of the capital stock of the American Telephone & Telegraph Co. on August 16, 1944, was $163.1875 per share, and on August 22, 1944, was $163.6875 per share.
These bonds were issued under an indenture between American Telephone & Telegraph Co. and City Bank Farmers Trust Co., trustee, dated September 1, 1941. The indenture provided in part that on not less than 30 days notice the bonds might be redeemed by the company in whole or in part on any date on or after September 1, 1942, ‘at the following redemption prices (expressed in percentages of the principal amount) together with accrued interest to the date fixed for redemption: to and including August 31, 1944, 107%; thereafter to and including August 31, 1948, 104%; thereafter to and including August 31, 1953, 102%; and thereafter, 100%.‘
The indenture further provided that the holder of any debenture bond ‘shall have the right, at his option, at any time after January 1, 1942, to and including December 31, 1954 (except that, in case any Debenture Bond or Debenture Bonds shall be called for redemption before such latter date and payment thereof duly provided for, such right shall terminate at the close of business on the date fixed for redemption of such Debenture Bond or Debenture Bonds) to convert * * * the principal of any such Debenture Bond * * * into such number of full-paid and non-assessable shares of Capital Stock of the Company as the principal amount of the Debenture Bond * * * surrendered for conversion is a multiple of $100 * * * at the price of $140 per share * * * , ‘ by the surrender of $100 principal amount of debenture bonds and payment to the company of cash equal in amount to the excess of the conversion price over $100.
The entire issue of these bonds was called for payment under the provisions of the indenture as of September 1, 1947, at 104, plus interest.
In his return for the taxable year petitioner claimed as a deduction, in computing net income, amortization of the premium paid with respect to his bonds in the amount of $8,638.75, representing the difference between $60,638.75 (the cost of the bonds) and $52,000 (the call price of the bonds at 104).
These bonds were the only premium bonds purchased or owned by petitioner in 1944. They were not part of the stock in trade of petitioner or includible in any inventory of petitioner at the close of the taxable year, or held by him primarily for sale to customers in the ordinary course of his trade or business, but were purchased by petitioner as an investment.
Petitioner, in 1944, did not sell any of the bonds or exercise his right of converting them into capital stock of the company.
When the coupon rate of interest carried by a bond issue exceeds the going rate for obligations of comparable desirability, the market will tend to place a premium on the bonds. If bonds are purchased for investment under such circumstances, the premium paid must be recovered tax-free out of the earnings of the bond1 very much as depreciation must be recovered out of the income of depreciable property if the true distinction between income and recovery of capital is to be preserved. Cf. United States v. Ludey, 274 U.S. 295. With this objective in mind,2 Congress in 1942 added provisions to the Internal Revenue Code permitting the amortization of bond premium by deductions from gross income.3
A complication bound to arise was the amortization of premium on bonds callable prior to maturity. Such obligations, although not included in the statute, are covered in a subdivision of the regulations dealing with ‘Callable and Convertible Bonds.‘4
The debentures purchased by petitioner in the tax year and which form the subject of this controversy were both callable and convertible. They were currently callable at the option of the obligor at any time on 30 days' notice at 104 per cent of face. They were convertible at any time at the option of the holder into common stock of the obligor upon payment of the difference between the face of the bond and 140 per cent of par.
Petitioner purchased the debentures at approximately 121 when the common stock of the obligor was selling at 163. Relying upon his interpretation of the statute and the regulations, petitioner deducted the difference between 104, the call price, and 121, his purchase price or basis, as a premium. The entire deduction was taken in the year before us, on the theory that the bond could have been called in that same year, and that in that event the entire premium would have been lost.
Respondent does not dispute such treatment in the case of a bond callable within the current year, but rejects petitioner's claim here because of the convertible feature of the debentures. His position was set forth in a ruling issued in 1945, dealing with the same issue of debentures as that now in controversy.5
Respondent's reasoning to justify rejection of the claimed deduction is not without force. He says in effect that what Congress was dealing with when it enacted section 125 was, as we have seen, the investment premium paid in excess of the call or maturity price of an obligation which was required to be paid in order to purchase interest income. Respondent's regulations, to be sure, do not provide that no bond ‘convertible into stock‘ is within the definition of an amortizable obligation, but that ‘the fact that a bond is * * * convertible into stock does not, in itself, prevent the application of section 125.‘6 This, however, advances us only to the point that the mere aspect of convertibility may not necessarily affect the possibility of the payment of an investment premium. Such would be the situation where the relationship between the conversion figure and the market price of the obligor's stock, eliminated value from the conversion privilege. See Badger, Valuation of Industrial Securities, p. 42.7 But in the present case, both the call price and the conversion figures indicate that the premium was paid, not for the investment feature of the bond, but for the rights of conversion.
The final reference in the regulation to a convertible obligation is that contained in the last sentence of the subdivision previously quoted,8 reading as follows:
* * * A convertible bond is within the scope of section 125 if the option to convert (on a date certain specified in the bond) rests with the holder thereof.
If this statement could be taken as fairly interpretative, and whatever its meaning may be,9 it seems clear that it could under no circumstances apply to these facts, and hence could be disregarded here. The debentures held by petitioner were convertible on any date from the minute he acquired them to their possible future call for redemption and consequently not on ‘a date certain.‘ The result of this sentence would then be neutral and leave open for consideration the question whether the section covered such convertible bonds as those held by petitioner.
The difficulty with respondent's entire position, however, is that it ignores the interpretation which Congress itself placed upon the legislation. In both the Ways and Means Committee report and the Finance Committee report10 there appears in identical language the following:
The fact that a bond is callable or convertible into stock does not of itself prevent the application of this section. In the case of a callable bond, the earliest call date will, for the purposes of this section, be considered as the maturity date. Hence, the total premium is required to be spread over the period from the date as of which the basis of the bond is established down to the earliest call date, rather than down to the maturity date. In the...
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