Rev. Rul. 60-210

Advice has been requested regarding the proper treatment, for Federal income tax purposes, of `discount' on certain interest-bearing bonds which were originally issued by a municipality at a price not less than par value.

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) 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 purchaser before redemption, each holder thereof was entitled to apportion the amount of 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.

These rulings were 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 had contracted to pay for the use of the money loaned and, hence, was equivalent to interest for Federal income tax purposes. Thus, if interest on a particular bond is wholly exempt from Federal income taxes, then any discount at which it was issued is also exempt.

On the other hand, municipal bonds purchased by investors from a dealer in securities who originally purchased such bonds from the municipality at a price not less than par value are not issued at a discount. In such case the discount at which the dealer sells the bonds to investors is not additional compensation otherwise provided or incurred by the municipality for the use of the money loaned to it. The municipality obtains the loaned funds from the dealer pursuant to the dealer's bid, accepted by the municipality, for the purchase of the entire issue of bonds at a fixed price. The dealer acquires ownership of the bonds as an original purchaser , and acts for himself, and not as broker or agent for the municipality in selling them to the investor. See Rev. Rul. 57-49, C.B. 1957-1, 62.

Accordingly, it is the position of the Internal Revenue Service that where securities of a municipality are originally issued at a price not less than par value and are subsequently acquired by a purchaser at a discount, such discount is not in the nature of tax-exempt interest. This discount is commonly referred to as `market' discount as opposed to `issue' discount.

Except in the case of certain corporations described below, such market discount is to be taken into account by the investor when realized by him. If such investor holds the bonds until redemption thereof by the municipality, he will then realize recognized gain of the entire excess of the redemption price received over the purchase price which he paid for the bonds. If, instead, the investor sells the bonds, he will then realize recognized gain of the entire excess of the sales price received or accrued over such purchase price, or sustain recognized loss of the excess of such purchase price over the sales price received or accrued. Such gains or losses to the investor will be taxable or allowable as capital gains or losses in accordance with and subject to the capital gain and loss provisions of the Code.

Section 822(d)(2) of the Code, relating to mutual insurance companies other than life or marine or fire insurance companies subject to the tax imposed by section 831, provides in part that in determining mutual insurance company taxable income the gross investment income shall be increased to reflect the appropriate accrual of discount attributable to the taxable year on bonds, notes, debentures, or other evidences of indebtedness held by a mutual insurance company. Similarly, section 818(b)(1) of the Code and corresponding provisions of prior law, relating to life insurance companies, provides in part that in determining taxable investment income under section 804 and gain and loss from operations under section 809 gross investment income shall be increased to reflect the appropriate accrual of discount attributable to the taxable year on bonds, notes, debentures, or other evidences of indebtedness held by a life insurance company. Thus, a mutual insurance company subject to tax under section 821 and a life insurance company must include in gross investment income the appropriate accrual of issue as well as market discount (determined in accordance with a proper method of accrual) attributable to each taxable year the bonds are held. See sections 1.822-3 and 1.803-6 of the Income Tax Regulations and the regulations under section 818(b).

The provisions of section 822(c)(1), 804(a)(2)(A)(i), and 809(d)(8)(A)(i) of the Code, relating to adjustments for interest which under section 103 is excluded from gross income, do not apply to market discount. Similarly, the provisions of section 803(c)(1) of the Code as amended and corresponding provisions of prior law, relating to adjustments for interest which under section 103 is excluded from gross income, do not apply to such market discount. However, the basis of the bonds shall be increased to reflect the amount of discount included in gross investment income for each taxable year the bonds are held. Where the bonds are held until redemption thereof by the municipality, no gain will be realized since the basis of the bonds, as adjusted for the accrual of discount, will be equal to the redemption price. Where the bonds are sold prior to maturity, gain or loss to be taken into account for the taxable year of the sale will be measured by the difference between the sales price and the adjusted basis of the bonds.

The following examples illustrate the application of the rules contained in this Revenue Ruling:

Example 1. A , not subject to the provisions of section 818 or section 822, purchased a $1,000 par value municipal bond from the City of R for $950 and held it until maturity at which time it was redeemed for $1,000. The $50 issue discount which A realized on redemption is treated under section 103 as tax-exempt interest and is, therefore, not includible in gross income by A .

Example 2. B , not subject to the provisions of section 818 or section 822 and not a dealer in securities, purchased a $1,000 par value municipal bond from C for $950. The bond was originally issued by the City of S at par. B held the bond until maturity at which time it was redeemed for $1,000. The $50 discount is not original issue discount and, accordingly, is not treated under section 103 of the Code as tax-exempt interest. Thus, the $50 gain B realized on the redemption of the bond is taxable as a capital gain in accordance with and subject to the capital gain and loss provisions of the 1954 Code.

Example 3. M , a mutual insurance company subject to tax under section 821, and L , a life insurance company, each purchased from the City of Q a $1,000 par value municipal bond for $950. Both M and L held the bonds until maturity when they surrendered them to the City of Q for $1,000 each. M and L must include in gross investment income the appropriate accrual of the $50 discount attributable to each taxable year the bonds are held pursuant to sections 822(d)(2) and 818(b)(1) of the Code. However, M , under section 822(c)(1), and L , under sections 804(a)(2)(A)(i) and 809(d)(8)(A)(i) are allowed a deduction or adjustment for the amount of issue discount included in gross investment income inasmuch as issue discount is treated under section 103 as tax-exempt interest. The basis of the bonds shall be increased to reflect the appropriate accrual of such discount. Accordingly, no gain will be realized on the redemption of the bonds since the adjusted basis of the bonds will be equal to the redemption price.

Example 4. M , a mutual insurance company subject to tax under section 821, and L , a life insurance company, each purchased a $1,000 par value municipal bond from P for $950. The bonds were originally issued by the City of X at par. M and L held the bonds until maturity at which time they were redeemed by the City of X for $1,000. Both M and L must include in gross investment income the appropriate accrual of the $50 discount attributable to each taxable year the bonds are held pursuant to sections 822(d)(2) and 818(b)(1) of the Code. However, they are not permitted, under sections 822(c)(1), 804(a)(2)(A)(i), and 809(d)(8)(A)(i), any deduction or adjustment for the amount of market discount included in gross investment income inasmuch as market discount is not treated under section 103 as tax-exempt interest. The basis of the bonds shall be increased to reflect the amount of such discount included in gross investment income for each taxable year the bonds were held. Accordingly, no gain will be realized on the redemption of the bonds since the adjusted basis of the bonds will be equal to the redemption price.

¹ Also released as Technical Information Release 230, dated May 18, 1960