Internal Revenue Service
Revenue Ruling
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smRev. Rul. 54-94
1954-1 C.B. 53
Sec. 163
IRS Headnote
Amounts claimed as `interest' in connection with certain so-called tax savings plans the purpose of which is to obtain an interest deduction for Federal income tax purposes are not deductible under section 23(b) of the Internal Revenue Code.
Full Text
Rev. Rul. 54-94
The attention of the Internal Revenue Service has been called to several situations where taxpayers are attempting to derive supposed tax benefits in connection with transactions designed to obtain interest deductions, for Federal income tax purposes. The question is whether the amounts designated as `interest' are deductible under section 23(b) of the Internal Revenue Codd. The following two examples are illustrative:
Example 1 . M Insurance Company has sold to the taxpayer an `annuity savings bond' (herein called the `bond') under the following conditions: Taxpayer `pays' to M a single cash premium of $100,000. To finance the premium, taxpayer pays $100 to M in cash and `borrows' $99,900 from M on a note that bears `interest' at the rate of 5 percent the first year and 3 percent thereafter. Taxpayer is not personally liable on the note, M's sole recourse being against the bond.
The bond has a maturity of 30 years. The `cash value' of the bond is $100,000 at the time the bond is issued and the `cash value' increases at the rate of 2 1/2 percent a year compounded annually. At maturity taxpayer will be entitled to an annuity based on the `net cash value' of the bond at that time, i.e., the excess of the `cash value' over the unpaid balance on taxpayer's note to M. Taxpayer has the election at maturity to receive in cash the `net cash value' of the bond, and if taxpayer dies before maturity a beneficiary named by him is entitled to the then `net cash value.'
(In some cases of this type it is provided that the taxpayer may surrender the bond at any time after 1 year and receive the `net cash value' thereof at such time. In some cases it is provided that the taxpayer may at any time borrow the `net cash value' on the bond on a nonrecourse note without surrendering the bond. In such cases there may be no `net cash value' at maturity and if so no annuity will be paid. In some cases it is provided that the taxpayer may at any time suspend payment of `interest' except to the extent of one-sixteenth of 1 percent without surrendering the bond, and the `cash value' of the bond will cease to increase during such suspension.)
Taxpayer claims that for Federal income tax purposes he may deduct the `interest' that he `pays' on the amount that he has `borrowed' on the bond, but that he realizes capital gain if he sells the bond. If this is so, and if taxpayer's surtax rate is sufficiently high, he will make a `profit' on the transaction notwithstanding that he pays 3 percent `interest' for a 2 1/2 percent investment.
Example 2 . In July 1952 taxpayer, an individual who is not a dealer in securities, purported to `purchase' $5,000,000 United States Treasury 1 3/8 percent notes due March 15, 1954, at $99. Taxpayer financed the `purchase' by making a small down payment and purported to `borrow' the balance from the N Company, a dealer in securities, on a 2 1/4 percent nonrecourse note maturing March 15, 1954, depositing the Treasury notes as sole security for the principal and interest on the note. N thereupon sold short the same amount of Treasury notes of the same series, and with taxpayer's consent N covered the short sale with the deposited Treasury notes, thereby receiving the funds which at had `loaned' to the taxpayer. Taxpayer may direct the sale of his Treasury notes at any time. It is contemplated that at or before maturity taxpayer will direct the sale of his Treasury notes, and N will purchase $5,000,000 of such notes at the then market price to cover its short sale.
(In some cases of this type the taxpayer `pays' part of the `interest' on the note to N with money `borrowed `from N on an additional nonrecourse note.)
Since the taxpayer will `pay' more `interest' on the note to N than the total of the interest and appreciation that he will realize on the Treasury notes, taxpayer will realize no profit on the transaction apart from the effect of the transaction on his Federal income tax. However, taxpayer, whose surtax rate is sufficiently high, seeks to make a `profit' by deducting the `interest' that he pays from ordinary income and reporting the gain on the sale of the Treasury notes as capital gain.
It is the view of the Internal Revenue Service that amounts paid by taxpayer and designated as `interest' in the above examples are not interest within the meaning of section 23(b) of the Code, and are not deductible for Federal income tax purposes. Cf. Old Colony Railroad Co. v. Commissioner , 284 U.S. 552, Ct. D. 456, C.B. XI-1, 274 (1932), where the Supreme Court indicated that interest is `the amount which one has contracted to pay for the use of borrowed money.'
In the above examples the amounts paid by the taxpayer are not in substance payments for the use of borrowed money. As a matter of substance the taxpayer does not borrow any money, hence there is no `debt' on which he pays `interest.' An instrument that is called a `note' will not be treated as an indebtedness where it does not in fact represent an indebtedness. See Talbot Mills v. Commissioner , 326 U.S. 521, Ct. D. 1660, C.B. 1946-1, 191; Matthiessen, et al. v. Commissioner , 194 Fed.(2d) 659. In example 1, part of the `interest' paid by the taxpayer will be returned to him through the increase in the value of the bond and the remainder represents a payment to M for arranging the transaction so that taxpayer may derive a supposed tax benefit. If it is possible to regard the transaction as an annuity transaction at all, the `interest' payments in reality represent the premiums paid for the annuity. If the transaction is regarded as an endowment contract, the `interest' deduction is to be disallowed under section 24(a)(6) of the Code. In example 2, taxpayer in substance pays a sum of money to the N Company for arranging a transaction pays a commercial substance so that taxpayer may derive a supposed tax benefit; taxpayer does not expect to make a cash profit on the transaction independent of Federal income tax consequences, nor does taxpayer risk the money that he `borrows.' Cf. Commissioner v. Transport Trading & Terminal Corp. , 176 Fed.(2d) 570, 572, where the Court of Appeals for the Second Circuit emphasized that `in construing struing words of a tax statute which describe commercial or industrial transactions we are to understand them to refer to transactions entered upon for commercial or industrial purposes and not to include transactions entered upon for no other motive but to escape taxation.'