Rev. Rul. 68-54

Advice has been requested whether certain registered subordinated debentures represent `indebtedness' for Federal income tax purposes.

X Corporation is engaged in the securities and commodities business and is a member of various securities and commodities exchanges including the New York Stock Exchange (`Exchange'). X proposes to issue registered subordinated debentures, the principal terms of which will conform to the requirements of the Exchange so that they will be recognized in computing X's `Net Capital' for purposes of Rule 325 of the Exchange. Under Rule 325, the ratio of `Aggregate indebtedness' of a member firm to its `Net Capital' may not at any time exceed 20 to 1. The proposed debentures, because they are subordinated to the claims of general creditors and others and because their transferability is restricted and there is no acceleration of maturity upon default in the payment of interest, will, for purposes of Rule 325, be recognized in computing `Net Capital' and will not be recognized in computing `Aggregate indebtedness.' `Net Capital,' as computed under Rule 325 is designed to reveal the minimum amount which would, under normal circumstances, be readily realizable by a member firm for the payment of claims of customers and general creditors.

The debentures that X will issue will mature 10 years after the date of issue and will contain no provision for the extension of the maturity date. Interest on the principal amount will be at the rate of 7 percent per annum. Additional interest contingent upon net profits will be payable but at a maximum rate of one percent per annum. The holder of the debenture irrevocably agrees that payment of principal and interest is subordinate to the unsubordinated claims of all other future and present creditors of X (including customers and general creditors of X ) arising out of any matter occurring prior to the maturity date. Other provisions cotained in the debentures are summarized below:

1. X may at any time prepay all or any part of the principal amount of the debenture after prior written notice to the Exchange and the holder of the debenture.

2. The unpaid principal amount of the debenture will mature, but will remain subordinate, in the event of any receivership, insolvency, bankruptcy, etc.

3. In the event that X exercises its option to purchase any shares of capital stock from a debenture holder under the provisions of its Certificate of Incorporation (i.e. where such purchase is `necessary or desirable for the welfare of X or for the attainment of corporate objectives'), the holder may tender the debenture for payment.

4. Any portion of the principal amount paid the holder must be repaid to X for the benefit of all creditors of X , if at the time of any payment, at or prior to maturity, X is insolvent.

5. Default in the payment of interest shall not accelerate the maturity of the debenture and the debenture will remain subordinate.

6. The debenture may not be transferred, sold, assigned, pledged or otherwise disposed of and no lien or other encumbrance may be created without the prior written consent of such securities exchanges, boards of trade, clearing corporations, or similar institutions which require such consent, and the approval of the Board of Directors of X .

The debentures will not be issued to any person who owns, or under the attribution rules of section 318 of the Internal Revenue Code of 1954 would be considered to own, any shares of any class of stock of X . In addition, no debentures will be issued to any trust forming part of a stock bonus, pension, or profit sharing plan of X for the exclusive benefit of its employees or their beneficiaries.

Whether an instrument represents indebtedness or an equity investment for Federal income tax purposes depends upon the facts and circumstances in the particular case; and there is no one factor which is conclusive in making such a determination. John Kelley Co. v. Commissioner , 326 U.S. 521 (1946), Ct. D. 1660, C.B. 1946-1, 191. In the instant case, subordination, contingent interest, restrictions on transferability and the lack of acceleration of maturity upon default in the payment of interest raise questions as to the true nature of the debentures. However, for the following reasons it is concluded that the debentures do represent indebtedness of X for income tax purposes:

1. The debentures are payable within a reasonable period of time and on a fixed maturity date.

2. Payment of principal and the fixed interest is not dependent upon the earnings or at the discretion of X . While the debentures do contain is determined additional interest which is dependent upon earnings, such interest is determined by a fixed formula, and payment of interest so determined is not discretionary.

3. While payment of both principal and interest is subordinated to the claims of general creditors, among others, claims of the debenture holders will have priority over the claims of holders of all classes of stock.

4. The debentures give the holders no voting or management powers in X .

5. Default in the payment of interest, while not accelerating the maturity of the debenture, gives rise to a cause of action which the debenture holders may maintain against X for nonpayment of interest.

6. X's present capital appears to be sufficient for the normal operation of its business.

7. The earnings history of X indicates that it is reasonable for the debenture holders to anticipate payment of interest and principal.

8. Based on all the surrounding facts and circumstances, it appears that the parties at the time of the issuance of the debentures intend to create a debtor creditor relationship.

Accordingly, (1) the debentures will represent a valid indebtedness for Federal income tax purposes; (2) interest payable on the debentures will be deductible by X under section 163 of the Code; and (3) repayment of the debentures will not be treated as distributions with respect to stock or as redemptions of stock respectively under sections 301 and 302 of the Code.

No implication is intended as to the Federal income tax treatment of any payments of principal and interest on debentures, issued other than in conformance with the facts and circumstances set out above. The Federal income tax treatment of each payment of principal and interest on debentures issued other than under the facts and circumstances set out above will be determined in light of all the relevant facts and circumstances of that particular case.