INSTRUMENTS ISSUED BY DOMESTIC BANK HOLDING COMPANY ARE DEBT OF THE COMPANY FOR FEDERAL INCOME TAX PURPOSES, AND PERIODIC PAYMENTS ON INSTRUMENTS ARE INTEREST

Rev. Rul. 85-119

ISSUE

For federal income tax purposes, should the instruments described below be treated as debt, so that amounts to be paid periodically with respect thereto will be treated as interest for purposes of section 163 of the Internal Revenue Code, or should they be treated as equity?

FACTS

Corporation (HC) is a domestic bank holding company subject to regulation by the Federal Reserve Board (FRB). HC's stock is traded on a national securities exchange and is widely held. It owns 100 percent of the stock of a subsidiary engaged in the commercial banking business. HC proposes to issue for cash $100x of instruments (Notes) described below.

Under FRB guidelines, HC, as a bank holding company, must meet certain primary capital requirements. Under those guidelines, primary capital includes common and perpetual preferred stock, capital and undivided surplus, and a limited amount of "mandatory convertible debt." The guidelines further specify that a subordinated debt instrument that is issued by a bank holding company and that is payable in the issuer's common or perpetual preferred stock or redeemable with proceeds from the sale of such stock constitutes "mandatory convertible debt."

Notes will be issued in a public offering, will be widely held, and will not be held proportionately to HC's stock. They will be offered at 100 percent of their stated principal amount. Notes will be issued either in bearer or registered form, will be freely transferable, and will mature in 12 years. Noteholders will not be entitled to vote or to participate in the management of HC.

Under the terms of the Notes, amounts designated as interest are payable quarterly in cash at a floating rate comparable to the market rate on similar subordinated debt instruments payable in money at maturity. These amounts are payable without regard to HC's earnings. Regulatory and state corporate law restrictions generally applicable to the payment of dividends are not applicable to such payments. If HC defaults on its obligation to make these quarterly payments, Noteholders can sue to compel payment of the amounts then due.

Notes are unsecured and subordinated to all present and future claims of general creditors of HC. Payment of principal may be accelerated only upon the bankruptcy, insolvency, or reorganization of HC. Upon the occurrence of one of these events, Noteholders are entitled to payment in money, in an amount equal to the face amount of Notes plus periodic payments that have accrued but remain unpaid, before any payments are made to shareholders.

At maturity or at an earlier redemption date, HC is unconditionally obligated to issue, in exchange for Notes, its own common or perpetual preferred stock having an appraised fair market value equal to the principal amount of Notes. The class of stock to be exchanged for Notes is left largely to the discretion of HC, and is not determined until shortly before maturity or redemption. The stock will be registered with the Securities and Exchange Commission and will be publicly traded. Upon receipt of notice of maturity or redemption, Noteholders may elect to receive this stock as payment for their Notes. Under the terms of Notes, Noteholders who do not make the election will be deemed to have received such stock and to have appointed HC to sell such stock on their behalf in a secondary offering, with the proceeds to be delivered to the Noteholders on the maturity date. HC is unconditionally obligated to effect the secondary offering, with the proceeds to be delivered to the Noteholders on the maturity date. HC is unconditionally obligated to effect the secondary offering at its expense and to sell sufficient stock to result in the receipt by nonelecting Noteholders of new cash proceeds equal to the principal amount of Notes. Failure by HC to perform on its obligation to effect the secondary offering and to deliver cash equal to the principal amount of the Notes would constitute a breach of HC's obligation and would provide the Noteholders with a cause of action for money damages under state law.

HC generally has the option to redeem Notes for cash or to pay cash for Notes at maturity, without jeopardizing the status of Notes as mandatory convertible debt under the FRB guidelines, provided that payment is made only with the proceeds from the sale by HC of its common or perpetual preferred stock. Payment from any other source must receive the approval of the FRB.

HC is not thinly capitalized. Whether the Notes constitute debt or equity, after their issuance HC will have a debt-equity ratio that is within the industry norm.

LAW AND ANALYSIS

Periodic payments made with respect to an instrument are deductible as interest under section 163 of the Code only if the instrument is a valid indebtedness of the payor. Whether an instrument represents indebtedness or an equity investment for federal income tax purposes depends on the facts and circumstances of each case. No particular fact is conclusive in making this determination. John Kelley Co. v. Commissioner, 326 U.S. 521 (1946), 1946-1 C.B. 191.

An analysis of all the terms and conditions of the instruments and all the facts and circumstances surrounding the issuance of the instruments indicates that HC and the purchasers of the instruments intend to create a debtor-creditor relationship, Rev. Rul. 68-54, 1968-1 C.B. 69; Rev. Rul. 73-122, 1973-1 C.B. 66, and that as a legal matter a debtor-creditor relationship will be created. Notes also contain many other attributes that are commonly treated as supporting debt characterization for federal income tax purposes. They are issued for cash at 100 percent of their face amount in a public offering, are widely held, are not proportionately to HC's stock, and have been designated by the parties as debt. Amounts designated as interest are payable quarterly, irrespective of earnings, at a floating rate comparable to the market rate of interest on similar debt instruments payable in money. Any default on the payment of such amount or amounts results in a legally enforceable right in the Noteholders against HC for payment of the amount or amounts in default. The Notes remain outstanding for a limited 12-year term and do not contain any restrictions on transferability. In addition, HC is not thinly capitalized and its debt-to-equity ration is within the industry norm. Noteholders are not entitled to vote or to participate in management. Finally, because the number of shares of stock to be issued at maturity in exchange for Notes is not fixed but is based on the face amount of Notes, Noteholders, during the term of the Notes, do not share in the increase or decrease in the market value of such HC stock. Compare Rev. Rul. 83-98, 1983-2 C.B. 40.

On the other hand, the subordination of the rights of Noteholders to the rights of general creditors as well as the provision for the issuance of stock in exchange for Notes at maturity are features indicating that Notes may constitute equity. Although Noteholders are subordinated to the rights of general creditors, on insolvency or bankruptcy Noteholders have the status of creditors and are entitled to priority, in payment of amounts denominated as principal and accrued but unpaid interest, over the claims of all shareholders. In form, Notes are payable at maturity in stock; however, for any Noteholder who does not elect to a secondary offering of this stock and to deliver, at maturity, cash equal to the principal amount of Notes. Failure by HC to perform on its obligation to effect a secondary offering and to deliver cash equal to the principal amount of the Notes would constitute a breach of HC's obligation and would provide the Noteholders with a cause of action for money damages under state law. Accordingly, in substance, Notes are payable at the Noteholder's option in a fixed amount of cash or in stock of equivalent value.

HOLDING

Notes represent debt of HC for federal income tax purposes. Periodic payments with respect to Notes constitute interest deductible by HC under section 163 of the Code (provided the requirements contained therein are satisfied) and includible by Noteholders in income under section 61.

No implication is intended as to the federal income tax treatment of any payments with respect to instruments issued under other facts and circumstances.