Rev. Rul. 57-49

Advice has been requested regarding the proper treatment, for Federal income tax purposes, of `discount' at which investors purchased from a dealer in securities certain interest-bearing serial municipal bonds which, together with other bonds issued by the municipality at the same time, were originally purchased from it by him for a lump sum slightly above the total par (face) amount of all the bonds.

The dealer in securities in November, 1955, made a bid to the City of R of 8004 x dollars, plus accrued interest to date of delivery, for 8000 x dollars face amount of its serial bonds composed of twenty-five series, of 320 x dollars face amount each, maturing in 1956 to 1980, inclusive, and bearing annual interest at four percent on ten series, two percent on seven series, two and one-quarter percent on five series, and one percent on three series, respectively. The amount offered for the bonds was a single lump sum for all of them, payable upon their delivery, without any allocation or specification of bid price as to particular bonds or series of bonds. The bid, accompanied by a substantial remittance to bind it, was accepted by the city and, pursuantly, it delivered all the bonds to the dealer in December, 1955. The bonds were issued with interest coupons attached and are redeemable upon maturity at par. In making such bid for all the bonds of not less than their total par (face) amount, the dealer specified rates of interest on the various series which he believed would result in the lowest available total interest cost to the city on all of the bonds and still enable him to market them at a net (overall) profit. In this connection, it manifestly was recognized that, sold separately, some of the series would sell at premiums, some at par, and some at discounts, and that some of the premiums and discounts would be very substantial in view of the wide variance between some of the series in maturities and interest rates, especially the latter. The city was prohibited by a statute of the State of P , wherein it was located, from selling any of the bonds at less than par. However, the important fact here is that all the bonds were originally purchased from the city by a dealer at a single unallocated price of not less than their total par (face) amount, pursuant to a bona fide and arm's-length bid and acceptance. The dealer thence offered and sold the bonds to the public at different prices for each series ranging from $121 per $100 face amount down to $68 per $100 face amount. All such purchasers were investors. They are holding the bonds as such and not as dealers.

Section 103(a)(1) of the Internal Revenue Code of 1954 provides that gross income does not include interest on the obligations of a State, a Territory, or a possession of the United States, or any political subdivision of any of the foregoing, or of the District of Columbia.

Although the exemption provided in section 103(a)(1), supra , expressly relates to `interest' on the obligations therein specified, it was held, in G.C.M. 10452, C.B. XI-1, 18 (1932), that the amount of discount at which noninterest-bearing state or municipal bonds were issued was exempt, under corresponding statutory provisions, upon its realization when the bonds were redeemed, and that, where the bonds were sold by the original purchasers before redemption, each holder thereof was entitled to apportion the amount of the (issue) discount according to the relative extent of his respective holding period. In I.T. 2629, C.B. XI-1, 20 (1932), it was similarly held with respect to the amount of discount at which interest-bearing municipal bonds were issued. See also G.C.M. 21890, C.B. 1940-1, 85. In O.D. 647, C.B. No. 3, 123 (1920), it was stated, `In no case may such exemption exceed the total discount at which the securities were originally sold by the State or municipality.'

Such rulings are based on the principle that discount at which bonds and similar obligations were issued constitutes compensation (where noninterest-bearing), or additional compensation (where interest-bearing), which the obligor has contracted to pay for the use of the money loaned and, hence, is equivalent to interest for Federal income tax purposes. Stated differently, the issue discount is recognized as being interest in substance although provided in the form of such discount. Therefore, if `interest' on a particular bond is wholly exempt from Federal income taxes, then any discount at which it was issued is also exempt.

All the municipal bonds involved in the instant case were originally purchased, together with other bonds issued by the municipality at the same time, by a dealer at a single unallocated price of not less than their total par (face) amount and, accordingly, were not issued at a discount. Nor does it appear that the discount at which the dealer sold some of the bonds to investors was additional compensation otherwise provided or incurred by the municipality for the use of the money loaned to it. As aforestated, the municipality obtained the loaned funds from the dealer pursuant to his lump-sum bid, submitted and accepted, at a price bove the total par (face) amount of the bonds which it issued to him for such funds. Such bid and acceptance were bona fide and arm's-length. He acquired ownership of bonds as an original purchaser , and acted for himself, and not as broker or agent for the municipality in selling them to the public.

In view of the foregoing, the discount at which the dealer sold to investors some of the municipal bonds originally purchased by him from the municipality at above par is not exempt to them as additional municipal bond interest, for Federal income tax purposes, upon its realization by them. If the investors hold the bonds until redemption thereof by the municipality, they will then realize recognized gain of the entire excess of the (par) redemption price received over the purchase price which they paid. If, instead, the investors sell the bonds, they will then realize recognized gain of the entire sale price received or accrued over such purchase price, or sustain recognized loss of the excess of such purchase price over the sale price received or accrued. Such gains or losses to the investors will be taxable or allowable as capital gains or losses, i.e. , in accordance with and subject to the capital gain and loss provisions of the 1954 Code.