Rev. Rul. 73-122

Advice has been requested concerning the Federal income tax consequences resulting from certain agreements described below.

Organizations which are members of the New York Stock Exchange (organizations) propose to issue subordinated debentures (debentures) as a means of raising needed capital. Presently, Rule 325 of the New York Stock Exchange (Exchange) requires the organizations to maintain a ratio of "aggregate indebtedness" to "net capital" of not more than 15 to 1. Rule 15 3-1 of the Securities and Exchange Commission is similar to that of the Exchange. The debentures are to be issued pursuant to a Secured Demand Note Collateral Agreement (collateral agreement) and a Cash Subordination Agreement (cash agreement). The debentures are to be payable within periods varying from one to ten years, each debenture having a specific maturity date.

Under the collateral agreement, the "lender" would issue a demand note (note) to the organization secured by marketable securities which, for the purposes of Rule 325 of the Exchange, would have a value (capital requirements value) equal to the unpaid principal amount of the note. The initial collateral for the note is to consist of securities and a minimal amount of cash. Any cash on hand resulting from the sale by the "lender" of the securities held as collateral for the note, as well as any cash on hand from the initial collateral, will not be held by the organization for more than 30 days without reinvestment (except for minimal amounts of cash which cannot be invested because of the small amounts involved). Any cash put up as collateral for the note is to be considered as a "loan" covered by the cash agreements (other than minimal cash). The collateral agreement requires the organization to sell on notice all or any part of the collateral whenever the Capital Requirements Value (for the purposes of Rule 325 of the Exchange) thereof falls below the unpaid principal amount of the note. The proceeds of such sale are to be applied in reduction of the "lender's" obligation under the note. At the same time, the organization is required to issue debentures to the "lender" in the amount of the reduction of the note.

Pursuant to the terms of the collateral agreement:

1. A fixed percentage of the unpaid principal amount of the note is credited to the lender as of the last day of each month as compensation to be paid by the organization for the use of the securities. Such compensation shall be paid to the lender at the end of each annual accounting period of the organization.

2. The lender has the right to withdraw the note and the collateral on a date which is not less than one or more than ten years from the date of execution of the collateral agreement.

3. The lender agrees to subordinate his right to withdraw the note and collateral to all claims of all present and future creditors of the organization and to claims which are expressly stated in the instruments creating such claims to be senior to claims of the type arising under the collateral agreement, which arise out of any matter occurring prior to any withdrawal, return, or reduction of the note under the agreement. The unpaid balance of the note remains subordinate after the fixed withdrawal date in the event of any receivership, insolvency, bankruptcy, assignment for the benefit of creditors or other similar events.

4. The lender is not personally liable for the unpaid balance of the note. The organization's only recourse in the event of default on the note will be against the collateral.

5. The lender (a) has the sole right to any voting power incident to the ownership of the collateral, (b) has the sole right to any income or any distribution received with respect to the collateral, and (c) the sole obligation to pay all taxes, assessments, and other charges arising by reason of ownership of the collateral.

The debentures may not be transferred, sold, assigned, pledged, or otherwise encumbered or disposed of, and no lien, charge, or other encumbrance may be created or permitted to be created without the prior written consent of the Exchange. The debentures also provide that, if the obligation of the organization to pay the principal amount of the debentures is ever suspended for a period of six months, the organization will promptly take whatever steps are necessary to effect a rapid and orderly complete liquidation of its business.

The terms of the cash agreement concerning the debentures are virtually the same as those of the collateral agreement. However, under the cash agreement the lender will transfer cash to the organization in return for its promise to repay the principal amount and interest.

Section 162 of the Internal Revenue Code of 1954 provides, in general, that there shall be allowed as a deduction all the ordinary and necessary expenses paid or incurred during the taxable year in carrying on any trade or business. See also, section 1.162-1 of the Income Tax Regulations.

Section 163 of the Code provides, in general, that there shall be allowed as a deduction all interest paid or accrued within the taxable year on indebtedness. See also, section 1.163-1 of the regulations.

The primary questions presented are (1) whether the debentures to be issued would be valid indebtedness for the purposes of the interest deduction under section 163 of the Code, and (2) whether the amounts paid for the use of the collateral under the agreements are ordinary and necessary business expenses under section 162 of the Code.

For the following reasons, the debentures which are to be issued pursuant to both the collateral agreement and the cash agreement constitute valid indebtedness.

1. The debentures are payable within periods varying from one to ten years although payment of the debentures may be deferred if, after giving effect to the payment, the organization would be in violation of the applicable requirements of any governmental organization or of the capital requirements of the Exchange.

2. Payment of principal and fixed interest is not dependent upon the earnings or at the discretion of the organization.

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

4. The debentures do not give the holders thereof voting or management powers in the organization.

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

Accordingly, it is held as follows:

1. The debentures will represent valid indebtedness for the purposes of section 163 of the Code.

2. The interest payable on the debentures will be deductible by the organizations under section 163 of the Code.

3. The collateral (securities and minimal cash) pledged by the lender pursuant to the provisions of the collateral agreement will continue to be the property of the lender prior to the time when, under the terms of the note to be issued pursuant to the collateral agreement, it is disposed of and income derived from the collateral will be income of the lender pursuant to section 61 of the Code.

4. The amount to be paid by the organizations to the lender is for the use of the collateral and is, therefore, an ordinary and necessary business expense under section 162 of the Code.

5. The amount (other than principal) to be paid by the organizations pursuant to the provisions of the cash agreement is deductible under the provisions of section 163 of the Code.

6. Repayment by organizations of principal amounts under the cash agreement and debenture will not be treated as distributions under section 301 of the Code. Also, the repayments will not be treated as redemptions of stock under section 317(b) of the Code. Accordingly, section 302 of the Code, relating to the treatment of certain distributions in redemption of stock, will not apply to the repayments.

7. If, in accordance with the terms of the agreements, the organizations sell all or any part of the securities collateralizing the notes, such sale by the organization results in recognized gain or loss to the owners of the securities involved.

Consistent with the principles of Revenue Ruling 68-54, 1968-1 C.B. 69, no opinion is expressed concerning the Federal income tax consequences (including the characterization of the debentures as debt or equity) resulting from the issuance of the debentures to a person who owns, or under the attribution rules of section 318 of the Code, would be considered to own, any shares of stock or have any interest in the organization issuing the debentures.