CORPORATION THAT TRANSFERS ASSETS TO TRUST FOR SOLE PURPOSE OF MAKING PAYMENTS ON ITS OUTSTANDING BONDS MUST INCLUDE TRUST INCOME IN ITS GROSS INCOME

Rev. Rul. 85-42

ISSUE

Whether a corporation that transfers assets to a trust that it has established for the sole purpose of making payments of principal and interest on its outstanding bond issue will be considered to have transferred the assets to its bondholders in satisfaction of the outstanding bonds, or, will the corporation continue to be regarded as the owner of the assets held in trust.

FACTS

Corporation X bought $300x of United States Government securities and contributed these securities to an irrevocable trust. The trust instrument directs the trustee, a commercial bank, to apply the trust corpus and the interest thereon solely to satisfy the scheduled payments of principal and interest on a $500x outstanding bond issue of Corporation X. The trust instrument further provides that neither Corporation X nor its creditors can rescind or revoke the trust or otherwise obtain access to the trust assets. Any amount remaining in the trust when the Corporation X bonds are retired will revert to Corporation X.

Because the government securities yield 14 percent and the outstanding Corporation X bonds yield only 6 percent, the $300x of government securities, coupled with the earnings thereon, will generate sufficient funds to service the $500x outstanding debt. Further, the government securities will provide cash flows (from interest and maturity of those securities) that approximately coincide, as to timing and amount, with the scheduled interest and principal payments on the outstanding Corporation X bonds. Moreover, because the assets of the trust are essentially risk free as to timing and amount of payments of principal and interest, the possibility that Corporation X will be required to make future payments on the outstanding bonds is remote. However, Corporation X is not legally released from begin the primary obligor on the outstanding bonds.

The Financial Accounting Standards Board has announced, in FASB statement No. 76, Extinguishment of Debt, Nov. 1983, that in trust arrangements such as the one described above, sometimes referred to as "in-substance defeasances," the debtor corporation shall consider the debt to be extinguished for financial accounting purposes.

LAW AND ANALYSIS

Section 1.61-13(b) of the Income Tax Regulations provides that if a corporation, for the sole purpose of securing the payment of its bonds or other indebtedness, places property in trust or sets aside certain amounts in a sinking fund under the control of a trustee who may be authorized to invest and reinvest such sums from time to time, the property or fund thus set aside by the corporation and held by the trustee is an asset of the corporation, and any gain arising therefrom is income of the corporation and shall be included as such in its gross income.

For financial accounting purposes, in accordance with FASB Statement No. 76, Corporation X will be considered to have extinguished the debt owed to its bondholders upon the transfer of assets to the trust because the assets are essentially risk free and the likelihood that Corporation X will be required to make future payments to the bondholders is remote. However, Corporation X is not legally released from begin the primary obligor on the bonds. Consequently, for federal income tax purposes, Corporation X cannot be considered to have discharged the debt owed to its bondholders upon the transfer of assets to the trust. See section 1.61-13(b) of the regulations.

HOLDING

Corporation X will continue to be regarded as the owner of the assets held in trust and any income generated by the trust assets will be includable in the gross income of Corporation X.